Insights & Advice

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The Ghost of Christmas Past

Tis the season to be overly optimistic about the year ahead of us. We reflect upon 2020 and commit (for about a month?) to New Year’s resolutions that will help us participate in what will undoubtedly be a better year than almost any prior.

 

I’m not talking about you and me. I am talking about the U.S. equity market.

The MSCI U.S. Index is comprised of 618 companies that represent large and mid-cap companies. It covers approximately 85 percent of U.S. market capitalization. The consensus expectation for aggregate earnings per share of this index is 20 percent for 2021. Even considering that overly optimistic expectation, equity valuations are so lofty, it suggests that investors are pricing in perfection for 2021 and continued good times for 2022.

The stock market is priced to perfection; valuations are not currently allowing a lot of room for error. The danger for the stock market builds when investors fully embrace a narrative. Investors are looking beyond what could be near-term economic softness in early 2021. They are assuming a stable and sustained expansion phase for years to come. It feels to me that speculation is in full gear.

I don’t think that it’s wrong to expect continued improvement in consumer and corporate activity. Economic recovery, COVID-19 vaccines, accommodative monetary policy from the Federal Reserve and other central banks, expected fiscal relief for households and businesses, and negative real returns (i.e., net of inflation) are all generous tailwinds for the prices of risk assets, such as stocks.

However, that’s all built into the stock market.

A couple weeks ago, I said while “I am constructive on a one-to-two-year horizon,” I have an unhelpful expectation of a 5-15 percent correction. I admitted it was unhelpful because 1) I am unsure of the timing, and 2) that’s a wide range. My strategy would be to accept the decline and “shift from large caps to small caps.”

My expectation of a pullback isn’t much of a gamble, given that the U.S. equity market is overbought. Stretched technical conditions and overly optimistic investor sentiment warn that equity prices are likely to be challenged in the short term — well, theoretically. I could have said the same thing this time last year. But then the market had another short-but-generous rally into January 2020. As that rally approached its end, I wrote a column titled “Just give me a reason,” in which I described a frothy stock market that was ripe for a pullback.

In that column, I detailed some of the high flyers, which graduated to become ridiculously high flyers over just a month. Suppose we get another rally before we get another decline. In that case, I may modify my intention of selling large caps to buy small caps and instead find a way to get more conservative.

I’ll gladly take one last rally and bask in the short-term merriment of what might feel like a Christmas miracle. But we’ve seen this holiday favorite before, and it often cameos the Ghost of Christmas Past, who reminds us that what goes up too fast comes down real fast.

The best 2020 holiday gift

The Ghost of Christmas Past is a metaphor for a Scroogey stock market. However, no matter if you light a menorah, put up a tree or dance around a pagan pole, our best gift for 2020 is viable COVID-19 vaccines.

At this point, we’re all well aware of the potential timetable for distribution of a COVID-19 vaccine in the U.S., pending emergency use authorization by the Food and Drug Administration. But just in case you’ve been smarter than the rest of us and have spent the last few months lost in some Oculus Quest 2 game, I’ll give you a loose rundown of when which people will be able to get their shots.

December – January:      Health-care workers (21 million people) and nursing home residents (3 million people)

February – March:             Those over the age of 65 with medical conditions, varying essential workers (education, food, transportation and law enforcement)

April – June:                           General population

Currently, the stock market expects this distribution to go swimmingly. My bet is that no matter which Ghost of Christmas Past appears, if this timetable goes as planned, then the stock market will stuff our stockings full of cha-ching. I suspect that the distribution will go smoothly. I’ll be maintaining exposure to the stock market.

As recently as Aug. 5, I warned that if the U.S. didn’t offer $1 trillion of aid for states and municipalities, that we would experience a double-dip recession in 2021. Less than two months later, I felt less apprehensive about that possibility. I detailed the potential rollout of a vaccine and referenced Pfizer CEO Albert Bourla announcing that it was a “likely scenario” that the company would be able to distribute a vaccine by year’s end. I stated that “I am invested in the equity market for the long term because I expect a safe and effective vaccine to be created.” Fortunately, for my portfolio as well as humanity, Bourla seems to be right. Because of that, I am much less concerned about a 2021 double-dip recession.

That doesn’t mean I have to ignore any upcoming stock market corrections. But I wouldn’t sell off a lot of equity when we do experience a correction. Yule be sorry if you do. Oh, deer. Did I really just say that?

Rotation from technology

For what seems like forever, I’ve heard the story that it’s time to dump U.S. technology stocks and buy, well, anything else. I am not ready to do that. However, I am becoming more comfortable with the idea of rebalancing my portfolios. Rebalancing a portfolio involves selling investments that have accelerated in price to the point where you own more of it than you should. Usually that’s a good idea, but sometimes it makes sense to hold onto your winners.

So why am I considering rebalancing my portfolio if it would mean reducing my winners? On Monday, Dec. 7, Bespoke Investment Group cited that the S&P 500 had made multiple new 52-week highs since September. However, the S&P 500 Technology sector had not made a new 52-week high for 50 trading days. There were 11 prior periods since 1990 when this has occurred. You can chop up the data in different ways. Still, for the most part, when the S&P 500 achieved new highs without Technology accompanying it, the broader S&P 500 has tended to outperform Technology in the months ahead.

I am ecstatic with where stocks are now. I think I’ll be pleased with where stocks will be a year from now. But somewhere between now and then, I am going to be less happy. The remedy to that sadness won’t take much, but it will require self-medication in the form of preemptive rebalancing and reactive reallocation from large-cap stocks to small-cap stocks.

This article originally appeared in The Berkshire Edge on December 14, 2020.

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Allen Harris is the the owner of Berkshire Money Management in Dalton, managing investments of more than $500 million. Unless specifically identified as original research or data-gathering, some or all of the data cited is attributable to third-party sources. Full disclosures: https://berkshiremm.com/capital-ideas-disclosures/. Direct inquiries to email hidden; JavaScript is required.