The first quarter (January to March) of 2021 saw a continuation of the market trend we saw in the last quarter (October to December) of 2020, which is an upward momentum in stock prices. The Vulcan Intrinsic Value portfolio gained 15.2% in the first quarter of 2021, over and above the 17.0% we gained for the full year of 2020. In comparison, the portfolio benchmark (70.0% MSCI All Country World Index, 30.0% Canadian Universe Bond Index) gained by 1.68%, the Canadian TSX Composite Index gained by 8.1%, the S&P 500 gained by 6.2% and the MSCI All Country World Index gained by 4.9%. For the Canadian, US, and global stock market as a whole, this quarter was driven largely by gains in value stocks, small cap stocks and by the energy, financial and consumer sectors.
The portfolio year-to-date return is slightly above our expectation relative to the rest of the market and, while we expect the market to remain at higher levels, it is likely that market gains will moderate from here. The concern now is that markets are overheated and we could be headed for a major correction.
Strategy Going Forward
Despite record levels for the market indexes, we are not rushing to sell our investments largely because several holdings are not yet at fair values. Having said that, our overall portfolio posture is defensive; i.e. we have been building up cash levels in the portfolio gradually since January and have begun to put hedges in place that will protect us on the downside. It is likely that as the market grinds higher our cash position will increase, as individual holdings are either trimmed or sold outright. We may not add equivalent investments if we’re unable to find any that meet our criteria. We have also shortened the investment time frame and stand ready to liquidate additional holdings should the market sentiment wobble.
The fact that the market is at an all time high is the inevitable outcome of all that has happened since the pandemic broke and the choices that were made by governments and central banks to hold this world together.
In our note to clients dated April 15 2020, we laid out the following: “While the economy is expected to contract for the next two quarters and a recovery beginning in early 2021, the stock market will discount this expectation approximately three to six months in advance. I fully expect the stock market to be in a new uptrend within 12 months and we will very likely see the stock market indexes reach new highs in due course.”
Today, a year down the line, we are at that new high!
At this juncture, we don’t expect any immediate dramatic fall in the stock market, though corrections of varying magnitude are very likely. We are more likely to see money flow from one sector of the economy to another, for example from technology to energy (sector rotations) and from one style i.e. value or growth to another (style rotations). What this means is that stock prices will fall and rise in smaller groups rather than an all out fall across the market. We will also continue to see the ebb and flow of speculative bubbles, which unfortunately do have the ability to impact future returns.
Managing Through Speculative Bubbles
Speculative activity remains at heightened levels in pockets of the stock market such as the tech sector, IPOs (technology and tech enabled businesses), Special Purpose Acquisition Corporations (SPACs), bond rates, crypto currencies and, famously, meme stocks. SPACs are an interesting phenomenon and a great example of how Wall Street banks and private equity funds quickly organize to take advantage of hyper market conditions.
I have received numerous questions on whether SPACs are something we would consider for our portfolio. The answer is that we would, but under very specific conditions, and would more likely consider a SPAC exchange traded fund (ETF) than direct holdings given the asymmetric risk profile of SPACs. However, the SPAC market already is showing signs of losing investor interest and the speculative element may have already worn off. Same story in the IPO market: in the first quarter 70 IPO’s have now dipped below their IPO price. Meme stocks such as Gamestop and AMC keep flaring up now and then but there are signs of fatigue in the more hyper-speculative parts of the market.
While tech sector valuations and the IPO rush are showing signs of moderating, rising US bond rates (the annual interest rate that the US government pays to borrow money for 2 – 30 years) are another story altogether and one that can at some level completely smash the stock market rally. However, the widely tracked US 10-year bond rate rising to 1.74% in March from 0.88% in January is not yet at that level. The week of March 22, when bond rates spiked, saw a very unsettled stock market. We would do well to remember that the 10-year bond rate is still only at the same level as it was pre-pandemic in March 2020. During 2016-2018, when the 10-year rate rose from 1.5% to 3.3% the S&P 500 rose from 2,000 t0 2,900 points. We have a long way to go before rising interest rates threaten the stock market rally.
Corporate Earnings Momentum; any future weakness is a key market risk
The key risk, in my opinion, is the ability of companies – globally, but particularly in the US – to keep up the spectacular recent earnings momentum. Earnings expectations are rising and any failure to meet raised expectations could dampen market sentiment. Any widespread failure of companies to meet earnings expectations will have serious consequences for the health of the stock market. The consequences will be severe because current market valuations are at historic highs. In that light, the most recent International Monetary Fund (IMF) forecast of 6.4% GDP growth for the US for 2021 and 3.5% for 2022 are both remarkable and an indication of how strong and resilient the most important economy in the world really is.