Summary

The stock market’s recovery continued in the first quarter of 2021 as all major categories of stocks made new highs.  For the quarter, U.S. stocks gained 6.17% (as measured by the S&P 500).  That said, the quarter was anything but a continuation of 2020’s themes.  This year’s market rally strongly favored smaller and more speculative companies.  Why? Because larger, safer companies do not tend to decline as much when the economy slides into recession, and they tend to begin their recovery sooner.  As investors gained confidence post-vaccine roll-out late last year, the worst hit stocks of 2020 began rebounding with a vengeance.  Cyclical industries (industrials, financials, transportation, chemicals, metals & mining, for example) performed extremely well, while those companies that soared in 2020 because of their leverage to the “stay at home” theme (largely technology and consumer durables) sold off heavily starting in February.  This necessitated an unusual amount of trading activity in order to adjust to the new trends.

International stock markets also gained, though they once again lagged the U.S. considerably.  Despite a net gain of 3.48% overall, conditions significantly varied between regions.  Europe outperformed other foreign regions as its recovery seemed to be on the same trajectory as America’s.  Japan, heavily dependent on exports, was negatively impacted by the rising value of the yen.  After a strong start, China lost over -4% on the quarter when the authorities began cracking down on Chinese internet companies.  Factoring China and Japan out, however, Asia would have had the best performance.  Latin America (-5.32%) was devastated by its collectively awful response to Covid.

Expectations for stronger economic growth pushed up interest rates, leading bonds to a -3.37% loss.  This was the worst quarter for bonds in many years.  High yield bonds were able to eke out a 0.85% gain as yields of over 4% offset mild interest rate-related capital depreciation.  For lower yielding investment grade bonds, there was no such reprieve.  Long term (10 year+) bonds lost over -10%, global bonds shed -4.46%, and mortgages were off -2.90%.  Just a tough quarter all around.  Fortunately, bond have rallied in April. Activity

Where to begin?  For starters, we had to shift stock exposure from an overweight to growth sectors like technology to cyclical value sectors like financial services and industrials.  We also increased the weighting in smaller company stocks as the economic recovery is broadening out.  The international part of portfolios also had to change; if cyclical stocks are moving in the U.S., they will soon be moving in Europe and Asia as well.  That said, the aforementioned crackdown in China has put an important part of the emerging market story on hold for the time being.  This has necessitated a rethink in what kind of emerging market funds you want to own.  Bond duration had to be shortened during the quarter because of rising interest rates.  During periods of recovery, we tend to lower bond credit quality to benefit from higher yields.  Lastly, for more aggressive investors we have carved out a small niche for emerging technologies such as digital assets.

Outlook

“It’s tough to make predictions, especially about the future” – Yogi Berra

At any given time, an experienced investment analyst can tell you what the markets expects.  For example, currently when interest rates rise, it is generally an expression of confidence in the economy.  This means economically sensitive areas of the market, like smaller capitalization and cyclical stocks, are expected to outperform.  On the other hand, if interest rates decline, it is probably due to concern about the economy, which means investors will prefer large, non-economically sensitive stocks that can thrive in a recessionary environment.

I can also tell you that investors expect that the economy will take off once the Covid crisis is truly behind us.  Pent-up demand for travel and leisure is expected to be off the charts.  Reflecting this, hotel company Marriott recently exceeded its previous price peak of $151.50 set in December 2019, and online travel giant Booking Holdings just hit an all-time high almost $300 higher than its pre-pandemic peak.  I am not saying either stock couldn’t go higher, but they appear to have already priced in the economic recovery.  At the same time, the consensus holds that inflation will surge during the first half of 2021 as production tries to catch up to surging demand.  By the fourth quarter, however, supply and demand are expected to come into equilibrium such that the near-term upward pressure on interest rates will dissipate.   In other words, the market is being driven forward almost relentlessly by the expectation of strong future growth but very modest interest rate increases.  Again, this might happen, but it makes me nervous when the market prices in the best-case scenario because I hate having more to lose from things going wrong than I have to gain from things going right.

This “goldilocks” narrative could be threatened by either weakness (Covid doesn’t fully go away and service-related businesses only partially recover) or by strength (the recovery drives up demand for everything from lumber to gasoline to plumbing services, and this results in sharply rising inflation).  Stocks tend to perform best in the early stages of an economic recovery, but you cannot stay in the early stages indefinitely.

Commentary

Recently, we have fielded a lot of questions about bitcoin and other cryptocurrencies.  Investors should know that financial professionals are under two limitations when discussing anything from an investment standpoint (be it Dogecoin, non-fungable tokens, or Hummel figurines).  The first is that as professionals we must have a reasonable basis for our opinion and are liable for that opinion (not unlike a doctor or an accountant would have if they gave general advice without understanding the client’s specific situation).  We are not free to just have an opinion.  The second is that our specific knowledge- that which we study and are tested on- has to do with matters that are quantifiable, such as “If a bond yields 5 percent and has 4 years remaining until maturity and inflation is steady at 3%, assuming no default risk, what should the price of the bond be?”  The equilibrium price of novel assets like Ethereum does not fall into that category because the price is purely a function of investor sentiment and supply/demand dynamics. Thus, we struggle to formulate a reasonable opinion.

Valuation questions that are purely matters of supply and demand are much harder to give good answers to, because it is difficult to forecast demand for something that has existed for a very short time.  When it comes to gold, a metal that has been a storehouse of value for close to 5,000 years, some of us may be willing to hazard an educated guess because there is some historical basis to work with.  We know it tends to correlate negatively to real (inflation-adjusted) yields, but beyond that the price of gold tends to venture into political/sociological territory (i.e. how do you feel about the near term prospects for your country?).  Therefore, when you ask us about Bitcoin, a cryptocurrency with a lifespan far, far shorter than that of gold, we tend to think “not only do I have no idea where it is going, but I am taking a certain risk having ANY opinion on it”.  Regulatory agencies have given us no guidance in terms of what we can say, but we know they are monitoring this area closely.

Determining the intrinsic value of any asset is difficult. Securities analysis training emphasizes cash flow valuation techniques and teaches analytical processes that when applied correctly, should help improve decision making.  It does not promise to always be right.  When it comes to determining what an asset’s underlying value is, I can use my training as a CFA to determine what I believe to be a reasonable estimate.  It may or may not agree with the market’s price for the asset, just as a gambler might advise you not to hit on 17 at the blackjack table only to see you draw a 4.  Statistically correct but specifically wrong.

To be clear, price and value are often used interchangeably but they are in fact two very different things.  Value, assuming you have the correct information, is a matter of expected future cash flow and mathematics.  Price, on the other hand, is a function of the dominant market narrative and supply/demand curves.  It probably belongs in the realm of soft sciences like psychology and economics, where people may behave rationally but are under no requirement to do so.  Case in point: Gamestop, the mall-based software retailer, had a market capitalization of $1.2 billion on January 8th, 2021 and $11.1 billion on April 19th.  I cannot justify the more than 9-fold increase in the price of that stock based on the cash flow prospects for the company, so I confidently believe that the current price ($164) does not represent good value.  I have no idea what the actual price will do.  Thirty, fifteen, or even five years ago I might have said that I expected that the price would decline.  Today, with rock bottom borrowing costs, essentially free trading, and easy access to information about what everybody else is doing (especially in the options market), all bets are off.  I can tell clients what I believe to be the prudent thing to do in the sense of risk versus reward because having spent thirty-five years in this business I understand how many ways the market can move against you.  Sometimes, however, people will take crazy risks anyway and they will pay off.

<1> MSCI EAFE in US dollars

<2> On the other hand, if you ask about blockchain or distributed ledger technology, you ARE asking us a securities question.  It would be similar to asking us about cybersecurity or genomics in the sense of “what do you think about these areas in terms of growth or investability?”, and we can feel more comfortable giving you an answer because we have researched these areas and can meet the standard of “reasonable basis”.

<3> Source: YCharts.com

<4> There is a delicatessen in New Jersey that does less than $50,000 in annual revenue that the stock market values at $101 million as of April 19, 2021.

Disclosure

Past performance is no assurance of future results. Trademark Financial Management, LLC (“Trademark”) is a registered investment adviser with its principal place of business in the State of Minnesota. Trademark and its representatives are in compliance with registration requirements imposed upon investment advisers by those states in which Trademark operates. Trademark may only transact business in those states in which it is registered or qualifies for an exemption or exclusion from registration. This newsletter is limited to the dissemination of general information pertaining to its investment advisory/management services. Any subsequent, direct communication by Trademark with a prospective client shall be conducted by a representative that is either registered or qualifies for an exemption or exclusion from registration in the state where the prospective client resides. A complete list of all recommendations will be provided if requested for the preceding period of not less than one year.   It should not be assumed that recommendations made in the future will be profitable or will equal the performance of the securities in this list.  Opinions expressed are those of Trademark Financial Management and are subject to change, not guaranteed and should not be considered recommendations to buy or sell any security. For information pertaining to the registration status of Trademark please contact Trademark at (952) 358-3395 or refer to the Investment Adviser Public Disclosure web site (www.adviserinfo.sec.gov). For additional information about Trademark, including fees and services, send for our disclosure statement as set forth on Form ADV from us using the contact information herein or by calling 952-358-3395. Please read the disclosure statement carefully before you invest or send money. Any reference to a chart, graph, formula, or software as a source of analysis used by Trademark Financial Management staff is one of many factors used to make investment decisions for your portfolio.  No one graph, chart, formula, or software can in and of itself be used to determine which securities to buy or sell, when to buy or sell them, or assist any person in making decisions as to which securities to buy or sell or when to buy or sell them.  Any chart, graph, formula, or software used is limited by the data entered and the created parameters. The data was obtained from third parties deemed by the adviser to be reliable. Nonetheless, the adviser has not verified the results and cannot be assured of their accuracy.

Summary

The stock market’s recovery from the COVID-influenced market sell-off in March accelerated last quarter as multiple pharmaceutical companies announced successful vaccine trials.  This news enabled investors to put a timeline on a return to normalcy.  They responded by shifting some of their assets away from firms that were doing well in the pandemic to those businesses that should profit most from the pandemic being over.  As a result, “value” as an investment discipline actually outperformed “growth” in the fourth quarter by 16.2% to 11.4%<1>, though the full year results remained lopsidedly in growth’s favor (38.5% to 2.8%).  Energy and financial services were the strongest sectors of the market last quarter gaining 27.8% and 23.2%<2> respectively, but neither managed to break even for the full year 2020.  Technology’s middle-of-the-pack 11.8% return kept it in first place for the full year with a 43.9% gain.  Investors have made technology easily the largest of all the eleven sector groups.

With a late surge, emerging market stocks just about equaled the S&P 500’s 18.4%<3> 2020 gain.  China led the major EM countries with a 29.5% gain for the year, but like the U.S. tech sector tapered off in the fourth quarter as EM investors shifted to Latin America and India.  Developed foreign markets trailed the U.S. for the year but outperformed it in the fourth quarter.  Both Europe and Japan gained over 15% in the final quarter compared to the S&P 500’s 12.2%.  The dollar was very weak in the fourth quarter, which almost always really helps foreign market performance.

The U.S. bond market returned a very strong 7.5%<4> last year as yields plunged in response to the Federal Reserve’s efforts to prop up the COVID-ravaged economy.  Only 0.7% of that return came during the fourth quarter, however.  Bond yields bottomed in late summer and rose modestly thereafter such that long term Treasury bonds actually declined in price in the fourth quarter.  The exception was inflation protected bonds (TIPs) which responded well to the fear that all the monetary stimuli would eventually prove inflationary.  TIPs were the best segment of the bond market in 2020, gaining 11.0%.  Investment grade corporate bonds were a close second at 9.9%.  High yield corporate bonds were the best performing segment of the bond market last quarter, rising 6.4%.  They finished the year up 7.1%.

In the wild year that was 2020, it should probably also be noted that gold rose 20.9%<5>.   Its return was negative in the fourth quarter, however, as the world began to look beyond the current crisis.

Activity

The vaccine news in late October sparked a surge into economically sensitive companies on the belief that they would be the biggest beneficiaries when the pandemic ended.  Therefore, the trade in the fourth quarter was to sell safe assets (such as bonds and certain stock sectors) and buy aggressive ones (small cap, value, and emerging market-oriented equities).  While the market moved somewhat away from the celebrated FAAMG group (Facebook, Apple, Amazon, Microsoft, and Google), it still strongly favored smaller disruptive firms like Square, Veeva Systems, Carvana, Datadog, Enphase, and Lemonade.  These are very speculative stocks which in many cases have negative net income (net losses).  We tried to find managers who we thought would be able to navigate this exciting yet dangerous segment of the market, and found ARK, Morgan Stanley, and Alger among others.  We also built up our international stock weighting by adding to both emerging and developing markets.  Many of our exchanges had the purpose of replacing defensive-tilting funds with those in the same category that were more opportunistic, because never in my career I’ve have I seen such a performance difference between established and unproven stocks – not even in 1999.  I don’t know how long the window will be open to maximize risk, especially since it usually closes with no warning, but it is certainly open now.

Figure 1: Growing Euphoria

Source: Peter Boockvar Outlook

First, given the divided political environment, I’d like to highlight the fact that we reminded our clients three months ago that the markets do not care about anyone’s politics.  Markets react to the outlook for future after-tax, inflation-adjusted corporate profits.  Period.  In the short run, the focus is going to be on COVID.  More specifically, did the market get ahead of itself in forecasting recovery or is it right to be looking beyond the pandemic?  I tend to lean toward the former, because the U.S. is behind where we thought it would be in terms of vaccinations at the same time that the virus is apparently becoming more contagious.  The narrative driving stock prices today is the expected pent-up demand post crisis.  While it is true that the stock market has not fully priced in economic recovery, it would still be in for an unpleasant short-term shock if we have to go back to a more severe quarantining environment.  The largest stocks in the S&P 500 have reached an average of 33 times forecasted 2021 earnings, which is in the top 1% of historic valuations.   Only time will tell if today’s investors were prescient or idiotic.  All I know is that it is really difficult to deploy capital for risk averse investors at today’s record high stock prices.  For more aggressive investors, I believe you have to take the risk and hope the current investment environment continues.

Figure 2: COVID Effect on Major Economies

Source: GZERO Media Commentary

The most significant development in 2020 was the rapid acceptance and adoption of new technologies.  The COVID crisis necessitated doing things from home, which dramatically compressed the time it would have taken companies like Zoom and DoorDash to become such a part of our daily lives.  In addition, it shortened the time it took concepts like gene editing and messenger RNA to become mainstream in medicine.  The resulting astronomical price gains in firms harnessing these technologies has led to a complete re-think in the investment community in terms of how we use terms like “growth” and “value”.  Nowhere will one find a better discussion of the evolution of the concept of value than Howard Mark’s brilliant piece, Something of Value<6>.  In it he argues against the simplicity of the traditional price-to-earnings or price-to-book-value approaches to value investing.  I will borrow from his essay liberally in discussing how I believe the stock market has evolved.

At the start of the previous century, it was commonly believed that bonds and preferred stocks were for investing and common stocks were for speculating.  The former paid dividends and had precedence in the event of a bankruptcy, while the latter offered much greater returns if the enterprise thrived.  During the first half of the 20th century, unfortunately, very few companies consistently did that.  Of the original 30 companies Charles Dow used to formulate the Dow Jones Industrial Average in 1896, only one (General Electric) remained an ongoing concern 100 years later – and now even GE has been kicked out.  In such an environment, Marks points out, the conservative “bird in the hand” type approaches tend to be favored.  The investors who became famous, most notably Benjamin Graham and Warren Buffett, were able to use a company’s financial statements to determine with a high degree of precision its present value.  In possession of that information, all one needed was the patience to wait for the company to trade a discount.  Given the manic-depressive nature of investors, “Mr. Market” routinely offered opportunities.

In the late 1960s, however, in response to technology (chiefly the transistor and the integrated circuit) offering improvements in communication and information processing, growth investing was born.  This discipline involved projecting how valuable a company implementing a new technology might become.  Marks stresses that this is inherently a more optimistic approach than value investing, but also subject to being wildly wrong (in both directions).  The first growth bull market came to a crashing halt in the early 1970s as the oil crisis and inflation pummeled the economy; many of those firms saw their orders dry up as the recession hit.  Growth investing got a second life in the 1980s with the advent of the personal computer, but it didn’t really explode until the commercialization of internet technology in the mid-1990s.  That was the biggest growth investing wave until the present one.

The importance of this lesson is not that each growth wave eventually met its end, but that each successive wave advanced growth as a discipline.  Growth investors realized that for companies to have a chance at long term success, they needed access to cheap capital and an investor base that would be willing to tolerate losses (sometimes huge losses) as the business “ramped up”.  That is the defining characteristic of the growth bull market of the 2010s and most especially of the market since the 2021 COVID plunge. Save for the electric vehicle credit, for example, Tesla actually lost money on each car produced until very recently.  Investors have been willing to focus on the future, so losses have been no obstacle for either the stock price or the company’s ability to raise more money by issuing stock. Revenue growth and market penetration have taken precedent.

One of the biggest takeaways from Marks’ letter is that there are so many more people in the investment industry right now relative to last century and more importantly, that they have access to almost infinitely more powerful technology for crunching numbers.  It is extremely difficult, therefore, to generate any advantage from understanding a given company’s financial statements better than anyone else.  This bull market has been led by those whose visions of what these new companies could become was boldest.  All of this being said, it is a completely open question as to how investors would respond to a sharp correction that targeted these new, disruptive companies (note that the COVID sell-off almost from day one punished older, more established company stocks worse).  Would investors hold their ground if Roku and Airbnb stock fell by half while PepsiCo and Caterpillar were going up<7>?  I have never found investors to be capable of holding their convictions for any length of time during which they were losing money while others were gaining.

Marks’ article points out that despite Ben Graham’s reputation for buying companies at less than intrinsic value, his biggest winner in his lifetime was GEICO, a growth company.  Warren Buffett has also benefitted mightily from growth stocks such as Coca-Cola and now Apple.  Success today seems to require intellectual flexibility, or the ability to adapt to what the market was offering you at a given time.  We are rigidly non-dogmatic here at Trademark.  Like everyone else we can determine what is working in the investment world, but we strive to understand why it is working and under what circumstances might it stop working.  Today we have a bull market fueled by low interest rates and an implied promise from Federal Reserve Chairman Jerome Powell that he will continue to provide ample liquidity to markets.  The global economy will almost certainly be much stronger in 2021 than it was in 2020.  These factors seem to warrant paying a higher price for stocks than at any point in the past, and certainly more than I ever would have guessed I would be willing to pay when I started in this business more than thirty years ago.  A super-accommodative Fed doesn’t ensure that stocks won’t decline, but it does suggest that unless investors completely lose their heads that any decline is likely to be muted.  We should continue to be in an environment in which new companies with innovative products can thrive.

<1> Value and Growth performance using Russell 1000 Value and Russell 1000 Growth, per Morningstar

<2> Sector performance courtesy of JPMorgan’s Guide to the Market, 4Q20.

<3> International stock performance from MSCI via Morningstar

<4> Bond performance from BBgBarc averages via Morningstar

<5> Gold return taken from the DJ Commodity Gold Index again via Morningstar

<6> Published in Seeking Alpha, January 11, 2011

<7> Essentially, it was sector rotation that killed off the previous growth bull markets more so than outright recession.

Disclosure

Past performance is no assurance of future results. Trademark Financial Management, LLC (“Trademark”) is a registered investment adviser with its principal place of business in the State of Minnesota. Trademark and its representatives are in compliance with registration requirements imposed upon investment advisers by those states in which Trademark operates. Trademark may only transact business in those states in which it is registered or qualifies for an exemption or exclusion from registration. This newsletter is limited to the dissemination of general information pertaining to its investment advisory/management services. Any subsequent, direct communication by Trademark with a prospective client shall be conducted by a representative that is either registered or qualifies for an exemption or exclusion from registration in the state where the prospective client resides. A complete list of all recommendations will be provided if requested for the preceding period of not less than one year.   It should not be assumed that recommendations made in the future will be profitable or will equal the performance of the securities in this list.  Opinions expressed are those of Trademark Financial Management and are subject to change, not guaranteed and should not be considered recommendations to buy or sell any security. For information pertaining to the registration status of Trademark please contact Trademark at (952) 358-3395 or refer to the Investment Adviser Public Disclosure web site (www.adviserinfo.sec.gov). For additional information about Trademark, including fees and services, send for our disclosure statement as set forth on Form ADV from us using the contact information herein or by calling 952-358-3395. Please read the disclosure statement carefully before you invest or send money. Any reference to a chart, graph, formula, or software as a source of analysis used by Trademark Financial Management staff is one of many factors used to make investment decisions for your portfolio.  No one graph, chart, formula, or software can in and of itself be used to determine which securities to buy or sell, when to buy or sell them, or assist any person in making decisions as to which securities to buy or sell or when to buy or sell them.  Any chart, graph, formula, or software used is limited by the data entered and the created parameters. The data was obtained from third parties deemed by the adviser to be reliable. Nonetheless, the adviser has not verified the results and cannot be assured of their accuracy.

Summary

The U.S. stock market gained 8.9%<1> last quarter as investors gained confidence that the worst of the COVID 19 crisis was behind us.  Ten of the eleven industry sectors gained ground, four of them by more than 10%.  The sole loser, energy, lost a whopping -19.7%.  This highlights the huge difference between winners and losers this year.  Technology stocks are up 28.7% and consumer discretionary stocks (think Amazon) are up 23.5% while energy stocks are down -48.1% and financial stocks are down -20.2%.  All of the industries associated with higher dividends (energy, financials, utilities, and real estate) are down, while the next three (consumer staples, communication, and health care) are up only single digits.  2020 has been about buying companies poised to grow from the surging online economy.  This just makes sense given our new COVID world.  The problem for investors is that many of these companies – Roku, Shopify, RingCentral, for example – are still losing money.  Others like Zoom and Tesla trade at price-to-earnings multiples north of 500.  For context, the long-term price-to-earnings average for the stock market is around 16-17.  There is no way to determine whether or not the online economy companies are fairly priced, since so much optimism seems to be baked into their stock price.  Therefore, it is our belief that they are less of an investment and more of a speculation.

Overseas, the returns were also pretty good.  The MSCI All world ex-USA rose 6.2%<2> in dollar terms, with Europe gaining 4.5%, Japan gaining 6.9%, Asia ex-Japan soaring 10.7%, and Latin America falling -1.3%.  Just like in America, the more the region featured technology the better it performed.  Those areas that were more natural resource dependent, such as Australia, Russia and Latin America tended to lag.  A world caught in recession where demand is falling is likely to continue to see weak commodity prices.  At the opposite end, Taiwan (all tech, no resources) rocketed up 16.5%.

Bonds are starting to feel the economic recovery as well.  Modestly rising yields all but wiped out the quarterly gains on treasuries while riskier categories of the bond market had yields high enough to register very decent returns. (Remember, as yields rise bond prices decrease, and vice versa) Overall, the bond market gained 0.6%.<3>  Inflation protected Treasuries (TIPs) soared 3.0% as inflation expectations rose.  Straight treasuries gained just 0.1% at both the short and long ends of the maturity spectrum.  Corporate bonds gained 1.5% as a whole, with A rated bonds up 1.1% and high yield “junk” bonds up 4.6%.  Emerging market debt returned to positive territory on the year with a 2.4% gain.  The relatively weak performance of the U.S. dollar this past quarter improved the return of foreign bonds to dollar-based investors.  It should be noted that more than 100% of the bond gains in the third quarter came in July and August; yields were backing up in September and that has continued into October due to expectations of a stimulus package.

Activity

As it became clear last quarter that the economy had bottomed in the second quarter, we began to take our cash levels down.  Not that we believe the economy is “out of the woods”, so to speak, but the market clearly wants to position itself for the post-COVID environment.  There is no question that the COVID crisis accelerated the adoption of online shopping and networking, so any investment strategist would be remiss not to incorporate that into their portfolios.  Of course, more aggressive portfolios can take greater risks on new and unproven companies.  The trick this year has been getting return for more conservative portfolios, because dividend-oriented stocks are still largely underwater.  In some client accounts, we added hybrid securities – investments which have characteristics of both bonds and stocks, such as convertible bonds – to try to improve returns.

Outlook

Politics can bring out strong emotions and biases, but investors should tune out the noise and focus on the long term. Many factors influence the long-term return of the stock market, but the party in the Executive Branch of government doesn’t seem to be particularly important. See Figure 1. As long as the government continues to function post-election, we’ll be okay.  The markets cares about corporate profits, both short and long term.  They will adjust to whatever reality they are presented with, but I can tell you the ONLY scenario they really fear is a protracted period of uncertainty.

Figure 1: S&P Returns Through Presidential Cycles

Source: Affiliated Managers Group

The main areas of uncertainty today are the length of the pandemic and whether or not our government is able to pass an economic stimulus package that includes direct transfer payments. The recipients of those payments tend to be lower income individuals who spend them quickly thereby spurring real economic growth. Therefore, if 2021 brings a reliable vaccine and a robust stimulus bill, we expect economically sensitive industries like machinery, banking, and energy to outperform technology and health care.

Commentary – Winning the Loser’s Game

Charles Ellis formulated one of the seminal ideas of investing in 1975.  Titled “The Loser’s Game” he argues there are two types of games, winner’s games (in which you play to win) and loser’s games (where you play not to lose).  A winner’s game, like golf, cannot be won by making par on every hole.  Each participant has to strive to do better than everybody else, which necessitates a fair amount of risk taking.  On the other hand, loser’s games, where Ellis believes investing falls, simply requires one to play not to lose.  Because there is no prize for coming in first, there are many risks Ellis argues investors should not take.  If you can avoid big losses, you can stay in the game (invested) for twenty or thirty years – maybe more if you’re young enough.  It’s almost impossible for your assets not to grow if your money is invested in a prudent manner for that long, he argues.

As you read the previous paragraph, you should notice two big caveats; “if you can avoid big losses” and “in a prudent manner”.  Of course, if you were to have bought Microsoft in 1986 and held it, or Apple in 1992, or Amazon in 1997, etc. you might laugh at the idea of caveats.  At some point your portfolio might have been 90% in that one amazing stock, and it still worked out for you.  Unfortunately, most of us are not going to have that kind of experience.  We are not going to find that home run stock way before everyone else, and even if we did, we would probably not be able to hold it during protracted downturns.  Would you have held Microsoft when it lost over 50% between December 31, 1999 and the end of May 2008?  Could you have held it while Exxon and other oil stocks were almost tripling over the same time period?  How about over the next nine months from June 2008 to February 2009, when MSFT would lose a further 40%?

The point is, building considerable wealth by finding and holding one or a small handful of stocks is very difficult.  It’s not something we can plan on.  Hindsight bias makes us think we would have held on to Microsoft but sold General Electric (which has lost over 80% from its peak), but we would probably be kidding ourselves.  If we accept that we are unlikely to strike it rich, we are left with managing our portfolio as a loser’s game – acting prudently and striving to avoid permanent loss of capital by employing diversification and patience.

Under all but the most dire historical circumstances, diversifying by industry type, market capitalization (company size), and geographical location has helped one avoid really big, permanent, losses.  More than four hundred years ago financiers put together syndicates to finance merchant shipping, because nobody wanted to be ruined if all their wealth was in one ship and it sank in a storm.  Today we can use asset classes such as bonds, precious metals and private real estate to better hedge against the risk of large losses.  The tools are there for us to “win” the loser’s game.  The trouble is, investors often are their own worst enemies.

It is very tempting to want to believe you can out-think everyone else.  For example, you may feel the impulse to sell due to the political party in charge of the White House. As we highlighted in Figure 1 above, that’s been a bad long-term strategy. Additionally, the idea that one can extrapolate industry winners from political events is just as misguided.  You couldn’t have done much worse than buying solar stocks when Obama was elected, unless you switched to oil stocks when Trump took office (in both cases you would have lost over half your money).<4>  Of all the harmful forms of conventional wisdom investing, election-related is among the worst.

Right now, investors are very enamored of technology stocks.  This makes sense given how rapidly we are adopting new technologies since the onset of COVID.  That said, the prices we are paying for MOST technology companies are ridiculous by any traditional valuation metric.  Every so often, the valuation rules are re-written to accommodate a hot sector – be it technology, pharmaceuticals, energy, etc.  This lasts until the expectations priced into the stocks get to a point where they cannot be supported by any growth scenario.  Eventually, investors start to realize that everybody else knows this too and the industry “reprices” significantly lower.  One cannot predict when we will reach that point, only that we always have in the past.  Nobody hands out free money<5> and the mathematics of recovering from steep losses are very daunting.

If this sounds a lot like the slow and steady wins the race argument, that’s because it is.  You want to be the “house” in Las Vegas, not the gambler on a hot streak.  There has been a huge, and growing, gulf between winning and losing stocks and industries over the past decade.  It reminds this multi-decade market veteran of past investment manias that ultimately didn’t end well, and so I recall Charley Ellis and his wisdom: keep your losses manageable.  Diversification doesn’t help you win the investing game, but if properly done it helps ensures that you won’t lose it.

<1> Source for all U.S. market and industry returns is JPMorgan Asset Management, 3Q20 Guide to the Markets, page 14.

<2> Source for region and country returns is Morgan Stanley Capital International, per Morningstar Workstation.

<3> Source: Barclay’s Aggregate Bond Index per Morningstar Adviser Workstation

<4> Using Invesco Solar (TAN) as a proxy for solar stocks and SPDR Energy Select Sector (XLE) as a proxy for the oil market.

<5> Once again Warren Buffett said it best “Nothing sedates rationality like large doses of effortless money” in Berkshire Hathaway’s 2000 Annual Report.

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