Taking a Look Under the Hood

January 26, 2021 · Written By J. Stephen Lee

As all of us continue in the shared experience of life and work in the ongoing pandemic, we hope that this communication finds you and your loved ones well.

It is impossible to count the words that have been written and spoken about the unique events of 2020 and the first weeks of 2021. Many of us have become numb to the seemingly ceaseless background drumbeat of disturbing and downright shocking news. So, we will not attempt to add to that litany of text here – we will simply note with gratitude that many difficult days are behind us, and while not being naïve, we look forward with hope to brighter days ahead.

Not surprisingly, financial markets have endured similar shocks to the system, and have reacted and been affected in surprising ways. Perhaps most startling has been the seeming strength of stocks in the face of such dire human toll and political turmoil. Indices such as the S&P 500, after a panic-driven plunge in the spring of 2020, have roared back to new records. It’s been clear sailing for everything, right?  Well…not exactly.

Underneath the hood of 2020 returns is a vast and historic gap in the leaders and the laggards. Indications of over-exuberance have become prevalent as FOMO – fear of missing out – has set in and traders chase after the same stocks regardless of price or valuation. New investors – many of them freshly minted traders on apps such as Robinhood and online forums such as Reddit – have embraced a handful of large and small technology companies and driven those prices to new high after new high. IPO’s are again in vogue, with some 75% wrapped as Special Purpose Acquisition Companies – essentially blank checks given to chase acquisition deals. In the exuberance, many connections to historical relationships and financial common sense have become untethered.

What many are ignoring or simply unaware of is that the unprecedented events around the pandemic have yielded similarly unprecedented (and we believe unsustainable) results in stock markets. It is increasingly difficult to find sober and reasoned voices. Jason Zweig of the Wall Street Journal recently noted that investing legends Warren Buffett and Charlie Munger have called the online trading frenzy an “echo chamber” that leads to crowd-following behavior which brooks no dissent. Tech infatuation is alive and well and reminders abound of the heady days of 1999 when all was said to be new. History is clear in the severe treatment afforded overheated stock prices when the euphoria wave retreats. And make no mistake, retreat it always does.

Diversification, a bedrock of conservative investing, has been simply overwhelmed by momentum chasing. Consider the chart below, comparing global “value” stocks to “growth” stocks since 1997. The gray bars represent U.S. recessions. Readers may recall that we have devoted attention to this in our past several communications. While “value” unambiguously outperforms growth over time, leadership can and does rotate. But in 2020, following the onset of the coronavirus environment, the return premium for “growth” exploded to record levels that defy gravity. The question is not whether large tech companies are important and vital to our economy (they are), rather, the question is can such lopsided short-term results be maintained? We believe not.

This relative gap is as large as it has ever been, exceeding by many measures the technology bubble of 1999 and the disastrous NASDAQ meltdown that followed. Longer periods of time have unequivocally favored a value emphasis over growth, as the chart below shows.

But current data has been precisely opposite, with the most recent three years leading to record disparity. Statistics can indeed cause our eyes to glaze over, but when observable data is – literally – the farthest outlier in history, one does not need to be a statistician to understand that is a signal to pay attention. See the chart below which reflects this fact.


In addition to the value/growth relationship, other indications abound that markets have become overly concentrated. Consider that headline indices were driven by just a handful of companies in 2020. Take away those companies, and the picture is drastically different.

The so-called FAANGM stocks (Facebook, Amazon, Apple, Netflix, Google and Microsoft) have resulted in the majority of this gap. Those six companies now make up nearly 25% of the S&P 500. While they have clearly been beneficiaries of pandemic-induced work-at-home environment and other behavioral changes, expectations seem to be far ahead of reality. Well known researcher Ed Yardeni recently noted these six companies that comprise nearly a quarter (23%) of U.S. index weight, yet contribute only 13.6% of earnings, and 1.6% of the revenues of the S&P 500. Interestingly and largely unheralded, accompanying the enthusiastic demand to buy those shares, the volume of shares of these companies available to trade has fallen by 26% as aggressive share buybacks have taken supply off the market. Demand in the face of decreased supply will certainly cause a price increase, but that phenomenon can be temporary. While undoubtedly good companies with good earnings, they are, as the saying goes, priced to perfection (if not beyond) with little to no room for disappointment.

What are the implications for long-term investing? From our perspective, the message remains clear – while variable in the near-term, financial market relationships inevitably revert to the mean. Patience and adherence to discipline is rewarded – particularly in times of extremes.

So, what does this mean for portfolios? We believe it means that prudent diversification will once again prove its worth, and greed will be penalized. Painful lessons learned in previous stock market disappointments tend to be forgotten when prices go seemingly nowhere but up and “everyone” has a story of a get rich quick success.

To affirm these thoughts, there are clear initial signs that an inflection point was reached late last fall. While the tech giants continue to sit as our largest companies, the rollout of COVID-19 vaccines and the conclusion to an extraordinarily contentious election decision in the U.S. have led to market dynamics signaling a shift. Many of the historical relationships we reference above are showing unambiguous signs of reverting to norms, steps that bode well for the benefits of diversification to reassert themselves.

New York Stock Exchange building at Wall StreetWhat about bonds? Stocks typically get all the attention – whether it be as the hero or the goat. But their less flashy cousins – bonds – also have a vital role to play when building solid portfolios and planning for future financial security. Because bond prices are driven in large part by interest rate movements, and because the majority of bond returns come from their coupon income, bonds tend to be less volatile. Thus, the bond component of diversified portfolios can be a crucial anchor.

Overlooked when times are good, high quality bonds earn their keep as an offset to stock volatility, as the chart below reminds. Note that when stock prices plunged in the spring of 2020, bond prices held steady and even gained slightly.  Thus while future bond returns are likely to be lower than the past, and this must be considered for planning purposes, bonds remain an important tool for intelligent portfolio construction.

As the saying goes, it is dangerous to drive a car while staring in the rear view mirror. So now that we’ve spent considerable time putting the past into context, what about the view ahead through the windshield? Acknowledging that no one has a perfect crystal ball, there are some observations that can be made.

In short, the vast changes to our world initiated by the pandemic remain and are not going away. There will certainly be lasting impacts that alter how we live, travel, socialize, and do business. Good companies will find ways to thrive and grow profits – as has been the case throughout history. And, in the midst of abrupt and unforeseen change, financial markets remind us that excesses of emotion-driven fear and greed remain alive and well. Yet, ignoring the repeated lessons of the past is a recipe for disappointment and disruption of financial plans. We will continue to keep our eye on the long game for all of you, and while being nimble, will not fall prey to sentiment-driven reaction.

On February 11, we will be holding a webinar – 2021: The Road Ahead – that will provide additional perspective and offer an opportunity for questions and dialogue. You can register for the webinar here if you haven’t done so yet. We have spoken with many of you in personal conversations and reviews in recent weeks, and look forward to this time for a broader discussion.

On behalf of all my colleagues at JFS, thank you for the confidence you place in us. We know that confidence must be earned continually, and we strive to do so. Maintaining portfolio and planning discipline in the face of headwinds – whether the headwinds are a light breeze or a gale, whether they engender euphoria or fear – is perhaps one of the most important roles we can play for you. Thank you for allowing us to do so.