Market Risk is Unavoidable But Not Unmanageable

January 8, 2021 – The year 2020 finished strong with what is now known as the “Everything Rally:” an acceleration of a bull market that began in late March after the one-month-long, 34% February to March stock market decline. This rally led US stocks to close out the year at all-time highs. “Everything” captures assets of all types simultaneously rising in price. Stock prices around the world, including emerging market countries, bonds, real estate, commodities, and crypto currencies like Bitcoin all rose higher.

These gains are predicated on massive amounts of fiscal and monetary stimulus from Congress and the Federal Reserve, together with optimism about the rollout of vaccines and the potential for even more fiscal stimulus. As more liquidity poured into the economy and optimism rose, prices of these assets continued to climb. Investors, in turn, looked for alternative opportunities, pushing one asset class after another higher and taking on additional risk for additional returns. Accepting risk is a reality of investing for growth. Historically investors could earn a return above the rate of inflation with minimal risk. In this low interest rate environment, an investor must accept risk to exceed even this current low rate of inflation. Risk avoidance is not an option for most investors. Risk management, on the other hand, is a necessity.

As citizens, political engagement is important and consequential to most areas of our lives. The financial markets, however, are dispassionate about party politics. For the markets, the lasting effects come from policies enacted. Market friendly or unfriendly policy is not the domain of a particular party. Consideration of policy stances on taxation, government spending, regulation, trade, immigration, environment, the dollar, to name a few, reveals that the market friendly position on each does not follow party lines. Do not be tempted to alter a sound personal investment strategy based on political winds. Instead, remain focused on your personal long-term objectives.

In October’s letter we discussed the markets functioning as forward-looking pricing mechanisms. The same factors that drove the markets in 2020—low interest rates, government stimulus, vaccines, and improving corporate earnings—will likely continue the same effect well into the new year.

We see the current U.S. stock market as fully valued. U.S. stocks are generally pricing in a strong economic recovery as soon as the second quarter of this year. Anything that delays that recovery or diminishes the expected results would likely add to market volatility. As usual, there are still areas of opportunity. We intend to own both the fast-growing beneficiaries of COVID disruption and the industries that are still in the recovery process. Many parts of the market have only recently begun to recover and continue to have upside potential: economically sensitive sectors of the market like industrials, materials and financials, as well as industries like travel and leisure.

In foreign markets, additional stimulus together with a trade agreement between Great Britain and the European Union should help European stocks make a comeback. In general, stock prices are not as high in Japan and most of Europe as in the U.S. A declining U.S. dollar makes foreign shares more valuable in dollar terms, which helps boost returns on foreign denominated stocks. We have an opportunity to rebalance toward foreign stocks in Europe and Japan, while including additional diversification in emerging markets when appropriate.

We expect bonds to have lower returns than normal due to historically low interest rates. However, bonds, or other low-risk assets, are necessary in most portfolios. Using a conservative approach, bonds are useful for risk reduction—but with low expected returns. The 10-Year Treasury bond ended the quarter at a yield of 0.91%, down from 1.92% at the start of the year. We prefer to build core portfolios of individual municipal bonds or high-quality taxable bonds, while supplementing with small allocations to specialty bond funds.

Among other asset classes, we have added allocations to convertible bonds, which have a blend of both stock and bond characteristics. Real estate, which we previously treated as an asset class, we now utilize as part of a stock allocation.

Although we provide an overview of many areas of the market, our focus when managing your portfolio is on your personal goal and an individualized strategy to reach that goal. We welcome your feedback and questions.