2021 CAPITAL MARKETS FORECAST
The Economy and Capital Markets in a Changed World UNCOVERING OPPORTUNITY ON THE ROAD AHEAD
WELCOME TO OUR
2021 Capital Markets Forecast The research and insight within this forecast serve as the foundation of our investment process. It informs the customized strategies we design to help each of our clients increase the probability of reaching their investment goals by maximizing risk-adjusted returns.
With the shock and aftershocks of the global COVID-19 pandemic, 2020 was a year unlike any other in history. It was turbulent, fascinating, frightening, and at the same time it showed us many timeless truths about the economy, the markets and humanity. As we turn our eyes to 2021, none of us can predict the future, but we can rely on time-tested research methods and innovative thinking to move forward thoughtfully together.
Contents The Balentine Building Blocks
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Uncovering Opportunities on the Road Ahead
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Wall Street’s Greatest Rivalry: Growth Versus Value
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What’s Ahead for 2021
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Appendix 28
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The Balentine Building Blocks As we consider near-term and long-term investment objectives in the context of our 2021 projections, we continue to base our strategy design on several foundational building blocks. Foremost, our investment philosophy is designed to create strategies that meet or exceed client return expectations while taking the least amount of risk required. The greatest risk to an investor is the permanent impairment of capital. We seek to lower this probability by managing overall strategy risk levels and customizing drawdown tolerance. Rather than viewing the total portfolio as a division of assets among primary asset classes (i.e., stocks, bonds, cash) or by the characteristics of the securities underlying those asset classes (i.e., growth, value, domestic, international), we choose to manage those factors by categorizing assets based upon their underlying risks.
Our primary building blocks are comprised of the following:
Fixed Income assets protect against short-term duress.
Market Risk assets seek to capture broad market returns.
It’s important to reinforce that we choose to create our strategies based on these building blocks, rather than the more simplified model of pure asset classes. This is because not all bonds, stocks or other investments are created equal. A bond, for example, should be considered for both its market risk and liquidity characteristics. In contrast, a very
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stable equity—while a risk asset—could serve the purpose of a fixed-income instrument. We discuss our portfolio strategies later in this document. With each investor we serve, we consider these building blocks within the context of their unique investment needs.
Helpful Definitions Throughout this forecast, you’ll see a few terms which are more technical in nature for some readers. Below are simple definitions for reference: Asset market – the set of markets in which investors buy and sell real and financial assets, including gold, houses, stocks, bonds and money. GFC – Global Financial Crisis Secular – refers to market activities that occur over the long term and tend to be relatively unaffected by short-term trends. A secular stock market is the market’s overarching trend or direction (upward or downward) for five years or more. Risk
asset – any asset that is not risk-free
Russell 2000 – commonly referred to as “small cap stocks,” is an index measuring the performance of approximately 2,000 American companies with market capitalization between $1 billion and $4 billion.
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Uncovering Opportunities on the Road Ahead Bringing context to 2020 volatility and complexity 2020 was one of the more volatile years in recent history for equities, as the market dealt with the potential impacts of Coronavirus. The daily volatility, as measured by standard deviation of large cap US stocks, was 37%—surpassed only by the uber-volatile year of 2008 (Figure 1). Note that the years with volatility in excess of the 30-year average each had a significant triggering event.
Figure 1. 2020 was as volatile a market as we have seen in the last 30 years, surpassed only by 2008’s epic volatility and the Global Financial Crisis. Year
Volatility
Event
2008
40.9%
GFC Crash
2020
36.9%
COVID-19 Crash
2009
27.6%
GFC Crash
2002
25.7%
Internet bubble bear market end
2011
23.7%
U.S. debt downgrade
2000
23.1%
Internet bubble bear market onset
2001
22.0%
Internet bubble bear market ongoing
1998
19.9%
Asian debt crisis
1991–2020
18.3%
2010
18.2%
Bull market
1999
17.6%
Bull market
1997
17.1%
Bull market
2018
16.9%
Bull market
2003
16.8%
Bull market
2007
15.8%
Bull market
2015
15.3%
Bull market
1991
13.6%
Bull market
2016
13.3%
Bull market
2012
12.9%
Bull market
2019
12.5%
Bull market
1996
11.6%
Bull market
2014
11.5%
Bull market
2013
11.1%
Bull market
2004
11.1%
Bull market
2005
10.3%
Bull market
2006
10.1%
Bull market
1994
9.6%
Bull market
1992
9.3%
Bull market
1993
8.5%
Bull market
1995
7.8%
Bull market
2017
6.8%
Bull market
Source: FactSet
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Note that the crashes, in general, are worse than the typical bear markets. Typically, crashes occur in the middle of bull markets, where stocks are not overly expensive compared to bonds. The catalyst for the crash runs its course, and the bull market continues. Eventually stocks become so expensive, that the ensuing downturn is typically not a crash but instead the onset of a bear market.
What are we to make of what we endured in early 2020? Crash or bear market? Recession or no recession? The answers to these questions are not simple. A bear market is traditionally defined as a decline in stocks in excess of 20%. Historically, however, bear markets have been a function not only of magnitude, but also of duration, with sustained periods of decline. Using the traditional definition would encompass a number of short, deep declines that were not prolonged periods of decline and did not end up derailing the ongoing expansion or equity bull market. To better answer this, we hearken back to our two key points in our discussion of the economic cycle that we outlined in our 2019 Capital Markets Forecast. Recall our economic cycle piece discussed: • The typical cycle begins from a trough in both the economy and the capital markets. • Capital markets usually move in advance of the economy because changes in expectations flow through to asset pricing far more quickly than they flow through to a change in economic activity. As the cycle progresses and slowly but surely vanquishes behavioral and capital markets headwinds, strength gathers in the economy. This leads companies to surpass expectations, which
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in turn drives further growth in capital markets and the economy. As both capital markets and the economy deviate too excessively from the trendline, both the economy (in the form of contraction) and markets (in the form of bear markets) adjust until the excesses are whittled away. Then the cycle begins anew. What we saw in 2020 was like nothing we have seen historically in the economy or the markets. It was a combination of a solid recovery with decent growth, reasonable earnings expectations, a lack of excess from consumers and corporations, and an absence of investor exhilaration—the sum total of which was flattened by a virtual meteor no one saw coming. So, what is the practical difference between this cycle and prior cycles? Quite simply, because the crisis was brought about by the exogenous shock of a pandemic rather than cyclical excesses, it is less likely that the usual prescription of low interest rates and excess liquidity will restart the economy despite the positive impact we’ve seen in the markets.
We believe there are three important takeaways to focus on going forward: 1. The economy and the markets are not one and the same. One can excel while the other is languishing.
2. “Creative destruction,” in which new technologies replace outdated ones, is a healthy part of capitalism despite the short-term turmoil it invariably creates. Markets can see through this and tend to adjust to it naturally.
3. Liquidity is a dominant factor, if not the most dominant factor, driving markets. Markets are likely to head higher on the back of liquidity before the next bear market ensues.
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Drawing Distinctions: The Economy vs. the Markets There is a larger and more frequent disconnect between the economy and the markets than many would think. The fact that one can walk down the street and see small businesses such as restaurants, drycleaners, personal trainers, auto repair shops and animal groomers leads one to erroneously overvalue the significance of these businesses, not only on the stock market but also on the economy. That is not to say they are not important. They simply lack the scale to move markets and the economy the way companies like Microsoft, Apple, Amazon, Alphabet, Netflix, Visa, Mastercard and others can. This idea has been addressed in countless ways. One particularly good example is a Bank of New York study that showed during 1970–2012 the correlation between quarterly gross domestic product (GDP) and S&P 500 price change was
only 12%. Moreover, the amount of change in the S&P 500 specifically attributable to the rise in GDP was a mere 1.5%.1 One may think that because capital markets move in advance of the economy, we could expect a higher correlation with GDP in the subsequent quarter rather than the concurrent quarter. This timing mismatch between investor returns and economy cash flows occurs because part of economic expansion results from savings being invested in capital rather than being spent on consumption. The gains resulting from those capital investments accrue to future shareholders, not existing shareholders. So, while it is true that there is an increased correlation with the subsequent economic period, the increased correlation of 28% remains relatively insignificant.
Stock Markets vs GDP Growth: A Complicated Mixture, July 2012
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Think of the relationship between the economy and the stock market as similar to the relationship between a boat and a skier being pulled by that boat: they will, over the longer term, trend in the same direction and will be tethered to each other. But over any short-term period, they can be moving in different directions, in different magnitudes, and at different velocities. Let us examine both the economy and the markets, in turn, with the understanding that they are not one and the same.
THE ECONOMY It’s important to set context before diving into an analysis. The 2020 Q2 GDP was reported to have declined 31.4%, only to be followed by a 33.1% rebound in Q3. These are shockingly large numbers in magnitude, but it is crucial to remember that GDP is reported as an annualized number. In truth, the decline in Q2 and rebound in Q3 were actually closer to 9% in actual GDP dollars.
Annualizing numbers can make quarterly figures look far more extreme than they actually are, both on the downside and on the corresponding upside. This is still a stunningly large decline, but it does take some of the edge off the headline number and ameliorate the magnitude of what seemingly occurred during the year.
The takeaway here is that the standard methodology of annualizing quarterly numbers can provide an appropriate annual perspective during “normal� quarters, but it is not practical for extreme circumstances such as what we experienced in 2020. With that said, concerns about deflation over what was still a severe economic shock drove the Federal Reserve to institute extremely loose monetary policy (far looser than anything experienced in our lifetime) between their interest rate policy and newly created liquidity facilities. This will continue to impact the economy somewhat. However, we need to see a more robust transition to fiscal policy in order to bring about a greater recovery in the overall economy. This is because monetary policy tends to have a disproportionately larger impact on the financial markets than the economy, whereas fiscal policy tends to have a larger impact on the economy.
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Expected winners and losers in 2021 WINNERS
✔ Technology companies ✔ Work from home (WFH) companies [companies that enable remote work]
✔ Sanitizer producers ✔ Psychiatrists
The Federal Reserve’s 2020 insistence that the central bank intends to keep rates low for a long time in order to support the economy amid pandemic shock (to quote Chairman Powell’s doubly emphatic, “not even thinking about thinking about raising rates”) means more financial repression for savers and more encouragement to take on leverage for spenders, businesses, and investors. It also most likely means businesses that are winners should take on more leverage to generate a higher return on equity if they are seeing commensurate demand for their products or services.
✔ Online and big-box retailers ✔ Video game companies ✔ Homebuilders LOSERS
✘ Hospitality and leisure (most notably airlines, cruise lines, hotels, casinos, live entertainment, movie theaters and theme parks)
✘ Department stores ✘ Restaurants ✘ New York City
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It’s critical to bear in mind that leverage is a two-sided coin. Business owners should be very confident in the direction of their business before taking on extra leverage. Just as leverage will magnify financial benefits on the upside, it can also greatly magnify poor returns on equity to the downside. But this higher leverage is less likely to cause systemic problems like it did in 2007, when we saw widespread overleveraging among businesses and individuals. This is because many businesses are lacking the top-line demand to take on leverage in the first place, and so many businesses and individuals are still jaded and have lingering debt aversion from the GFC.
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Inflation, deflation — or both? Technology is moving at light speed, which is deflationary. However, commodity prices and recent rises in interest rates are hinting at a future that is inflationary. We may actually see both, given the large disparity in winners and losers and the velocity of money crashing for losers and accelerating for winners. It will ultimately depend where all the money flows. Unlike prior contractions, when velocity of money slowed consistently across all sectors of the economy, with only minor differences among different companies and sectors, this contraction saw money effectively rerouted from one set of companies (the “losers”) to another set of companies (the “winners”). This strong divergence between the winners and losers was historic. Winners saw revenues and stocks explode, while losers saw revenues and stocks collapse and they also endured many bankruptcies.
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The cyclical nature of history and creative destruction Every generation feels as if they are experiencing fulcrums in history. Yet while it often feels like “life will never be the same” in those moments and for a short time thereafter, the reality is that life may change but the economy is rarely impacted structurally. One example is airlines after 9/11. The flying experience was and remains quite different after that event. Security measures have evolved, non-passengers are no longer allowed in gate areas and technology used by the industry has evolved. But airlines and their basic industry dynamics have stayed essentially the same. Even after the demise of many worthless companies in the bursting of the internet bubble, the economy remained structurally sound and continued to move forward. Perhaps many estimates of the eventual greatness and strong impact of those companies were just 20 years ahead of their time. Within an economy, old companies die out and new companies are born. This is what economist Joseph Schumpeter coined as “creative destruction.”
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While there are some large companies that stand the test of time such as Cigna (founded in 1792), DuPont (founded in 1802) and ColgatePalmolive (founded in 1806), the reality is that most companies eventually die out or evolve into something else. That’s because the engine of capitalism is constantly innovating products and processes to drive productivity and efficiencies that serve to replace archaic production methods and end products. In doing so, a great deal of excess capacity is produced in the short run as a result of capital investment to drive productivity upgrades. Such upgrades are a large portion of the investment component that comprises GDP growth, and they allow the economy to transition and continue to grow while the excess capacity is amortized away permanently. An important distinction regarding excess capacity brought about by creative destruction vs. excess capacity during a standard cyclical slowdown is the way in which such excess is reduced. Cyclical slowdowns affect temporary levels of excess capacity that merely need to be whittled away via population growth and productivity improvements. An ideal example is the housing surplus after the GFC. There was going to be an eventual need for homes as the population grew and as family formation resumed after the recession; the eventual return in demand was a just a matter of time. In the meantime, homebuilders adjusted by scaling back for some time. In the case of the fallout from the pandemic, however, there is capacity for which demand may never return as the economy
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secularly transitions. This will take time, but the economy as a whole always ends up better off in the end. Consider the change in the components of the Dow Jones Industrial Average (DJIA) in the last 50 years. The change, not only in the companies themselves but also the sector composition of the index, shows how the economy has changed from a hard-asset, capital-intensive economy to a capital-light technology base in a relatively short period of time. This is very much a result of creative destruction rendering many companies and industries obsolete. Another example potentially coming to a head is the energy sector. Although the energy sector is showing a rebound to end 2020 after a cataclysmic decline during the pandemic, it raises an important question:
Has improved technology and efficiency in the sector (which has had a positive effect on the overall economy in the form of lower input cost) simultaneously put the industry on the path to obsolescence? This obsolescence would be the result of structurally lower fuel prices in perpetuity resulting from permanent improvements in extraction methods and a growing shift to alternative fuels. In fact, look at all the household names in the index today that that were not in the Dow Jones Industrial Index 20 years ago, much less 50 years ago (Figure 2).
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Figure 2. The DJIA composition has undergone almost a complete turnover during the last 50 years… 1/1/71
1/1/21
Figure 2 (cont.) …with many sector changes over the last 20 years as well.
1/1/01
1/1/21
Chevron
3M
Procter & Gamble
American Express Boeing Caterpillar Coca-Cola Disney Home Depot Intel IBM Johnson & Johnson JP Morgan McDonald’s Merck Microsoft Procter & Gamble Walmart Alcoa Amgen AlliedSignal Apple AT&T Chevron Citigroup Cisco DuPont Dow Eastman Kodak Goldman Sachs Exxon Honeywell General Electric Nike General Motors salesforce.com Hewlett Packard Travelers International Paper UnitedHealth Group Philip Morris Verizon SBC Communications Visa
Allied Chemical
3M
Alcoa American Can Company
American Express Amgen
Anaconda Copper
Apple
AT&T Boeing American Tobacco Caterpillar Bethlehem Steel Cisco Chrysler Coca-Cola DuPont Disney Eastman Kodak Dow Esmark Goldman Sachs Exxon Home Depot General Electric Honeywell General Foods Intel General Motors IBM Goodyear Tire & Rubber Johnson & Johnson Inco Limited JP Morgan Chase International Harvester McDonald’s International Paper Merck Johns-Manville Microsoft Owens-Illinois Nike Sears Roebuck salesforce.com Texaco Travelers Union Carbide UnitedHealth Group U.S. Steel Verizon United Technologies Visa Westinghouse Electric Walgreens Boots Alliance Woolworth
United Technologies
Walmart
Walgreens Boots Alliance
Sector
1/1/71
1/1/21
Δ
Sector
1/1/01
1/1/21
Δ
Consumer Discretionary Communication Services Consumer Staples Energy Financials Health Care Industrials Materials Technology
5 1 4 3 0 0 9 8 0
4 1 4 1 4 4 3 2 7
(1) 0 0 (2) 4 4 (6) (6) 7
Consumer Discretionary Communication Services Consumer Staples Energy Financials Health Care Industrials Materials Technology
3 2 4 1 3 2 8 3 4
4 1 4 1 4 4 3 2 7
1 (1) 0 0 1 2 (5) (1) 3
Source: Dow Jones
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Source: Dow Jones
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There is absolutely no precedent for 2020. The best any experts can do is to make a best-effort attempt to interpret what has occurred and may lie ahead. Our interpretation is that rather than a protracted bear market, what we have experienced is an ultra-accelerated cycle that cleansed out certain aspects of the economy while sharply boosting others. Put differently, the forces of creative destruction ran their course quickly. The shift in spending patterns since early 2020 has brought about creative destruction more quickly than typical and does seem to show evidence of more permanence than we would normally see. That’s because consumer behavior patterns have changed and continue to change in the aftermath of COVID.
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Acceleration of creative destruction in the form of expanded innovations (most notably in technology), has been reflected in capital moving from archaic technologies and industries and into those that are generating productivity improvements. This is happening at a rate not seen in decades, if ever. The key question is whether we are seeing once-a-century or twice-a-century advances— like the cotton gin, internal combustion engine, light bulb, telephone or internet—which will drive productivity trends permanently higher. Our default hypothesis is that this is indeed the case, but this will be known with certainty only in hindsight.
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Another timely example of creative destruction are the innovative work-from-home and play-from-home technologies which are likely here to stay, upending our reliance on many structures previously deemed to be irreplaceable. Think offices, hotels, airlines and gyms. That is not to say these will disappear entirely, but suddenly a great deal of excess capacity has surfaced, and the landscape may never look the same. And what will be of industries such as commercial real estate, for example? As one of the most highly affected industries in the wake of the pandemic, questions swirl about what’s next on this front. A few possibilities to consider: Offices: They’re not going away completely. Companies may need more office space (so that the same number of employees will be able to fit into more space in order to allow for adequate social distancing). Or they may need less office space because of a permanent, widespread shift to working from home. The situation is very fluid at the moment, and it will take some time for clarity to emerge here.
Retail space: Even though retail sales have been slowly shifting online for years, COVID caused a dramatic shift toward online and away from physical retail shopping. Like offices, retail spaces will not vanish; however, the leap in online sales naturally means less brick-and-mortar will be needed while there will be greater need for storage and distribution centers.
Medical building: Healthcare represents 20% of domestic GDP, and the advent of telehealth is fundamentally changing how medical practices deliver services. And surveys show that patients prefer the efficiency and appreciate not having to drive, park and wait in crowded waiting rooms only to spend a few rushed minutes with a doctor. Given these facts, signs point to the telehealth trend continuing. Creative destruction could mean these places end up as distribution centers, data centers, or perhaps even storage facilities if oil surpluses reassert themselves. The only certainty is that more changes are coming. What’s uncertain is which ones and how long they’ll last. As noted previously, some ongoing change is a normal part of capitalism. But necessity is the mother of invention. And in a post-pandemic world, changes such as technology adoption are being compressed into an entirely new time scale of months and weeks rather than years.
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THE MARKETS In the shorter term, while we do not want to say the markets have looked totally past COVID, they have been pricing in better-case scenarios for a while now. At this point, there are reasonable bear cases and bull cases to be made:
Bear scenario: • While the economy did bounce back in Q3, it is still dealing with the effects of the greatest quarterly decline in history. Though the end of the pandemic is in sight as vaccine developments keep progressing, the virus is still not under control and additional spikes continue to make it more challenging to fully open many segments of the economy.
Bull scenario: • Short-term interest rates of zero will likely continue to feed through to asset prices via both an increase in the discounted value of future cash flows as well as investment flows into equities. Liquidity increases will provide a bridge for people and businesses. The Fed has committed to long-term support (as mentioned earlier, the Fed governors are “not even thinking about raising rates”). • Ultra-loose monetary policy will lead to more financial repression, with low interest rates for the foreseeable future. But individuals with assets are in good shape, just as they were in good shape after the GFC, when risk assets were also rewarded. Investors are scared about retirement and their ability to generate adequate income because of the effect of financial repression on the income levels that come from traditional bonds. While an argument can be made that total return (i.e., capital gains plus income) is most important, psychologically it is hard for investors
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to move from spending income to spending total return because income is predictable—whereas total return is not. (In general, individuals are naturally afraid to spend capital gains.) Note that we explore in later pages of this forecast why we believe the emphasis should be on total return. • Tax policy moving forward is uncertain, but it is going to take time to reveal itself regardless of the results of the Senate election. So, any tax concerns will be on the back burner for a while and should have little effect on the markets and tax planning in the near term.
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High notes in the market As we examine markets on the back of the great rebound from the COVID low, four themes become evident:
Stocks are not expensive relative to bonds or historic valuation multiples. With bond yields as low as they are now (up from their Coronavirus lows but still extremely low by historical standards), there is still much room for them to rise before stocks could be considered expensive relative to the yield level. In terms of historical valuation multiples, the S&P 500 had a cyclically adjusted P/E ratio (CAPE ratio) of 45.8 at its peak in 2000, at a time when the 10-year Treasury yield was 6.25%. With the current 10-year Treasury yield hovering under 1%, the current CAPE ratio stands at 32.4. So, at the current level of 10-year earnings, the S&P 500 would have to trade at 4300 to match the CAPE ratio of March 2000. And, of course, earnings will grow as the economy rebounds from the recent stresses.
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If we look at valuations on current earnings vs. cyclically-adjusted earnings, the question becomes this: What is the appropriate earnings yield of the U.S. stock market (i.e., the reciprocal of the P/E ratio) at the current level of interest rates? We would argue there is certainly the potential for valuations to expand further. The standard formula for the P/E ratio as represented by the present value of a perpetuity is 1/(r-g), where r represents the discount rate and g represents the growth rate. So, for example, if the appropriate discount rate is the 10-year Treasury (e.g., ~1%) + a historical risk premium (e.g., ~3%), and we assume a relatively modest earnings growth rate in perpetuity of 2%, then our earnings yield would calculate to 1/(1%+3%-2%). This would calculate to a P/E of 50 or an earnings yield of 2%.
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NOTE: We are not definitively calling for the index levels or valuation levels previously cited. Rather, we are merely pointing out that getting to such levels using fundamental analysis is by no means a stretch. In summary, the equity markets could conceivably go a decent amount higher before our model and history would consider the market to be sufficiently expensive to predict an imminent bear market.
Market trends look like early cycle. As 2020 comes to an end, the trends in the market are most historically aligned with early-cycle trends. This buoys the theory that COVID served as a catalyst for the creative destruction that has given rise to new companies and technologies that will drive the bull market higher. We currently see strength in small cap equities, financials are showing signs of life after having been dead for so long, and commodities are breaking out. Even energy stocks, which are facing strong secular headwinds, are showing signs of life as the market begins to price in life after Coronavirus.
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Concentration risk is not as much of a concern as it would appear. Is it “different this time” in terms of the largest components of the market index? We are always loath to say that, given it is rarely “different this time.” The largest components of the S&P index are robust tech stocks which, when compared with the index titans of the past, seemingly have 1) larger moats, 2) less cyclicality, 3) greater secular tailwinds, 4) and strong balance sheets with less need for additional capital. Additionally, the valuation ratios of these companies are less of a concern because the earnings being used to calculate the valuations are restrained because the companies have higher earnings flexibility. In other words, because they can generate higher earnings at any moment by pulling back on reinvestment within the company, investors reward the companies with reasonable PEs on the normalized earnings, which come off as excess PEs on earnings considered to be understated by the market.
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Liquidity is likely to be the dominant factor. What about the increased liquidity from the Federal Reserve? Liquidity injections are nothing new. But as we said when the Fed first issued its liquidity at the onset of the pandemic, their moves were very decisive. The agency used virtually all its policy weapons to stimulate demand, buy time and limit economic fallout. In short, they bypassed the bazooka in favor of a Howitzer.
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Excess Fed liquidity over the recent decades has typically found its way into the asset market rather than into the hands of those most impacted by the economic damage. This is because generally these injections serve to shore up the banking system and keep investor confidence higher. The Fed generally relies on Congress to effect fiscal stimulus in order to get money directly into the hands of consumers, as the Fed is impotent to do such. The result of this cannot be overstated as we saw how quickly markets rebounded after bottoming in March, while many small businesses at ground zero of the economy (e.g., restaurants, hotels) continued to struggle.
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Wall Street’s Greatest Rivalry: Growth Versus Value Yankees vs. Red Sox, Packers vs. Bears, Celtics vs. Lakers – throughout sports history, fans have witnessed intense rivalries that have lasted decades. Often, one team will dominate the rivalry for a couple years. Then a couple years later, the other team will have the upper hand, and the rivalry continues. The phenomenon of a rivalry is not unique to sports, and one of the strongest rivalries today can be found on Wall Street. The investment rivalry of Growth vs. Value has built up over the past few decades and lately the competition seems to be a bit lopsided. Although Value has struggled recently, the rivalry persists, and investors are left to wonder which style will outperform going forward.
The History of Growth vs. Value In order to fully understand the rivalry between Growth and Value, we must first recognize the history. For decades, Growth stocks and Value stocks have been pitted against each other because they reflect fundamentally different investment philosophies. A Value stock is typically classified as a stock that is trading below its intrinsic value. In other words, it can be purchased at a discount and allows the investor to outperform the market as the stock increases in price to reach its intrinsic value. On the other hand, a Growth stock’s valuation is based on large earnings expectations and growth potential that is expected to outpace the market. The stark difference in investment styles tend to create sustained periods where the strategies perform quite differently. As shown in Figure 3, since Russell began tracking the difference between Growth and Value in 1979, the average outperformance on a calendar year basis for either style is just under 10%. A material difference in investment philosophies and significant outperformance can create quite the rivalry.
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Figure 3:
Growth vs Value: Calendar Year Performance
40% 35% 30% 25%
Average Outperformance: 9.7%
20% 15% 10% 5%
1979 1980 1981 1982 1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018 2019 2020
0%
Growth Outperformance
Value Outperformance
Source: Factset
A more recent story that emerges in Figure 3 is the outperformance of the Growth style. Since 2017, Growth strategies have outperformed Value strategies during four consecutive years, including 2020. Expanding our time horizon a little further, Growth strategies have been outperforming Value strategies since the recovery began after the Great Financial Crisis in 2008. While the recent
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outperformance of Growth has been significant, advocates of Value strategies will be quick to point out that starting in 2000, Value strategies outperformed Growth strategies for 7 consecutive years. These sorts of long-sustained cycles between Growth and Value have persisted through time and are one of the characteristics that make this such a great rivalry.
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Which Side has Done Better? As human beings, we tend to weight recent outcomes more heavily than outcomes in the more distant past. This tendency is referred to as recency bias, and the Growth vs. Value rivalry is a great example of this. Judging by the recent history, one would suspect that Growth strategies have drastically outperformed Value strategies throughout time. However, as depicted in Figure 4, the performance is far more similar than most would expect. If an individual had invested $100 into the Russell 1000 Growth index in
January of 1979, that $100 would be $12,522 as of the end of 2020. The same $100 invested in the Russell 1000 Value index would be $10,711. At first glance, a difference of almost $2,000 appears meaningful, however over a 40-year history that is only a difference of .42% annualized excess return. Even more remarkable is the fact that if this data were measured as of February 2020, the results would be flipped. The value of the $100 invested in the Russell 1000 Growth index would be $8,615, compared to $9,208 in the Russell 1000 Value index.
Figure 4:
Growth of $100: Growth vs. Value $12,522 $10,711
$12,800 $6,400 $3,200 $1,600 $800 $400 $200
1979 1980 1981 1982 1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018 2019 2020
$100
Russell 1000 Growth
Russell 1000 Value
Source: Factset Past performance is not indicative of future results.
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How to Account for the Rivalry in Your Portfolio With an intense rivalry like the one we have witnessed between Growth and Value over the last 40 years, investors find themselves in a conundrum: How do they position their portfolio going forward?
Typically, investors make one of two choices: 1. Establish a static allocation to both styles and keep it in your portfolio through time. This strategy has merit because over a longer time horizon, Growth and Value have provided similar performance. Which may also reduce the risk of underperforming the benchmark.
2. Actively tilt the Value and Growth allocations based on expected market outlooks. Although this strategy requires more due diligence and increases risk of underperformance, it could outperform because these styles have indicated that some environments are better suited for Growth or Value. The optimal choice between the above options will vary for each investor and will be dependent on risk appetite and return expectations. For an investor more focused on reducing portfolio tracking error from the benchmark and limiting active management risk, Option 1 may be the correct choice. However, for an investor seeking higher potential returns and less concerned about active management risk, Option 2 may be the more prudent choice.
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For those investors looking to outperform their benchmark, the second option tends to be the preferred choice. Investors looking to outperform are beginning to utilize a tactical manager that has demonstrated the ability to successfully shift between the Growth and Value styles over time. To represent the potential value of these tactical shifts, we simulated the performance of a manager that correctly shifted to the better performing asset class between Russell 1000 Growth and Value at the exact top and bottom of each cycle since 1979. The results are included in Figure 5. Figure 5:
Strategy
Annualized Performance Since Inception (January 1979)
Russell 1000
12.2%
Russell 1000 Growth
12.2%
Russell 1000 Value
11.8%
Simulated Tactical Portfolio
16.8%
Source: Balentine, Factset (gross of fees) Model results are hypothetical. See disclosures for more information.
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Understandably, being able to time these decisions perfectly can have a significant impact on performance. However, experienced investors know that attempting to time the market is a futile effort. While timing the market is impossible, there are
managers out there that have developed repeatable processes for capturing the majority of tactical shifts between Value and Growth — one example being Balentine’s proprietary Growth vs. Value model that began in 2000 (figure 6).
Figure 6:
Growth of $100: Value Add of Tactical Approach $1,600 $800
$769
$400
$410 $400 $380
$200 $100 $50
Balentine Tactical Model
Russell 1000 Growth
Russell 1000 Value
Russell 1000
2020
2019
2018
2017
2016
2015
2014
2013
2012
2011
2010
2009
2008
2007
2006
2005
2004
2003
2002
2001
2000
$25
Source: Balentine, Factset Past performance is not indicative of future results.
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As shown in figure 6, a tactical model with a repeatable process for shifting between Value and Growth could provide significant value for an investor. A tactical model can be successful within asset classes like Value and Growth because the pair has displayed long, discernible cycles that enable tactical managers to outperform a static allocation. From January 2000 through December 2020, $100 invested in the Balentine Tactical Value and Growth strategy resulted in $769. This is compared to $380 for the Russell 1000 Growth index, $400 for the Russell 1000 index, and $410 for the Russell 1000 Value index. In terms of annualized return, the Balentine model would have returned 10.2% from January 2000 through December 2020. This is lower than the 11.5% of annualized return for the simulated portfolio with perfect timing, however the Balentine model still represents an excess return of over 300 bps versus the annualized return of the Russell 1000 benchmark (6.9%). Therefore, for those investors grappling with
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allocation decisions between Growth and Value and looking to diversify from a strategic asset allocation, there are tactical strategies available that could represent the most effective option, given the long, discernible Growth and Value cycles.
End Game How the rivalry between Growth and Value will play out over the next couple of years is difficult to predict. The most important decision for investors is not which team will win the rivalry, but how effectively their portfolio is positioned to meet their return and risk objectives. Investors looking to improve upon strategic allocations should consider a tactical strategy, especially when considering an allocation to asset class styles that have displayed long, discernible cycles. With an appropriate Growth vs. Value allocation, investors can sit back and enjoy the game.
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What’s ahead for 2021: feast or famine? The public markets are becoming a feast-or-famine, winner-take-all battle royal where the few top performers capture a large share of the rewards and the others capture crumbs. Additionally, companies don’t stay on top forever. Passive investors in the S&P 500 will have 23% of their investment in five companies, and the other 77% in 495 companies. Apple, Microsoft, Amazon, Google and Facebook have run laps around the rest of the market and deserve their place at the top. But a quick look back at 1980 will show the top five companies then were IBM, AT&T, Exxon, Standard Oil of Indiana and Schlumberger. That’s a complete turnover in the top performers. While Apple, Microsoft, Amazon, Google and Facebook are currently feasting, there are other parts of the market experiencing famine. An investor who wanted to own something besides mega cap names could buy a basket of small stocks in the Russell 2000. Once the minor leagues for large cap companies (in fact, once home to Apple, Microsoft and Amazon), the cost of going public has forced many companies in this group to stay private for longer. This has caused the Russell 2000 to be populated by struggling companies that cannot graduate to the big leagues or companies that cannot find capital elsewhere.
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To this point, 48% of all companies in the Russell 2000 do not show a profit, a percentage nearly double that of its long-run average (26%). Meanwhile, private companies continue to grow and then go public as large-cap names. For example: Peloton went public with an $8.2 billion valuation Zoom went public with a $9.2 billion valuation Facebook went public with a $104 billion valuation By comparison, Amazon was valued at $438 million ($710 million inflation-adjusted in today’s dollars). While Peloton, Zoom and Facebook may all be great companies, the amount of return that can accrue to public investors is nowhere near the 120,000% an Amazon IPO holder has experienced.
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Fed intervention and the long-term squeeze on rate-dependent investors A different phenomenon is occurring in the public debt space: the persistent intervention of the Federal Reserve. The Federal Reserve’s balance sheet has consistently grown since the 2008 crisis. There was a short period where it began to shrink and the market reacted to rates it saw as rising too quickly,
which led in part led to the turbulent fourth quarter of 2018. Essentially the Fed threatened to take away the candy, and then quickly changed course again as the market stomped its foot and screamed, announcing around Christmas that it would not raise rates (in order to satisfy the markets and quell the tantrum—an act any parent can relate to in desperate times).
Recession 2007–2009
Coronavirus Recession
$7T $6T $5T $4T $3T $2T $1T August 2007– Present Source: Federal Reserve Board of Govenors via FRED, July 2020 This illustrates the Fed’s balance sheet since the 2008 crisis and just how active they have been in buying bonds.
1
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The knock-on, secondary effect of their buying and intervention is interest rates below 1%, putting a squeeze on conservative investors who have depended on bonds to provide a ballast in their portfolios and income for spending. With a Fed that is supposed to be fully independent but which has shown repeatedly it will be there as a backstop to the market (with an accommodative policy of artificially low rates), it is hard to see this trend changing. In the case that it does, and rates revert higher, those bond holders are going to take a hit on their capital as bonds lose value as interest rates rise. Thus, the combination of the winner-take-all in equity markets and meager returns in the bond markets leads us to believe the typical 60/40 stock/ bond portfolio will experience lower returns and higher risks over the coming cycle. Highlighting the importance of our tactical rebalancing through our Tier I (Stocks vs. Bonds) and Tier II (Equity Sub-Asset Classes) construct.
In Closing We hope you find this year’s Capital Markets Forecast informative in understanding what is realistic to expect in the months ahead from today’s starting point and what possibilities exist to achieve investment goals. In summary, with risk-free interest rates at rockbottom levels, it is imperative that investors seek to provide reliable capital preservation in times of duress while still meeting return expectations. Aside from increasing exposure to alternative income asset classes, like private credit, investors may be able to limit downside risk while still participating in up markets by expanding tactical capabilities within their portfolios. Expanding tactical capabilities, either through the use of a tactical manager or by developing an internal process to implement tactical allocation changes, may provide investors with additional options in the event of a sustained market correction.
If you would like to discuss any aspect of this Forecast and its implications within your own portfolio, please reach out to Darlene van Nostrand at dvannostrand@balentine.com. We appreciate this opportunity to share our outlook with you and look forward to helping you navigate the year ahead with clarity and confidence.
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Appendix Each year, we update our forecast of capital market returns for the next market cycle—as measured by the succeeding seven-year period—because future market returns are a function of the starting point, specifically, projected income and projected adjustments to valuation. As a result, the goal for our strategic forecast is to update our outlook to account for year-over-year changes to the starting point of the new seven-year cycle.
This happens because high profits and momentum attract investors and drive down future returns in highly-valued asset classes. Our update includes answers to the following questions:
We update our strategic forecast for asset classes on an annual basis, but that does not mean these are tactical, one-year allocations. Instead, our updated returns contemplate the market’s actions during the preceding year and rely on mean reversion. Over the long term, markets show a strong tendency to mean revert to historical averages adjusted for underlying trends.
Based on our updated projections, we restructure our strategic asset allocation targets in key areas to maximize the efficiency of our strategies and, therefore, better meet investment objectives over the next market cycle. Our forecast provides the quantitative blueprint for the steps we are taking designed to both manage risk and maximize opportunities in 2021 and beyond.
What public market returns are realistic during the market cycle? What risks may have to be assumed to capture those returns?
Fixed Income YTM
Duration
Bloomberg Barclays U.S. Aggregate
1.2%
6.2
Bloomberg Barclays U.S. Treasury
0.6%
7.2
Bloomberg Barclays U.S. (7Y–10Y)
0.8%
7.5
Bloomberg Barclays Municipal Bond
1.1%
5.1
Bloomberg Barclays U.S.Aggregate Credit - Corporate - Investment Grade
1.9%
8.8
Bloomberg Barclays U.S. Aggregate Credit - Corporate - High Yield
5.1%
3.6
Bloomberg Barclays U.S. Treasury Inflation Protected Notes (TIPS)
0.8%
3.8
Bloomberg Barclays Global Aggregate
0.9%
7.4
JP Morgan EMBI Global Diversified
4.6%
8.0
Return
Risk
MSCI All Country World (Global equities)
5.4%–7.9%
16.5%
Russell 1000 (U.S. Large Cap)
1.0%–3.2%
14.5%
Russell 2000 (U.S. Small Cap)
1.7%–4.0%
19.2%
MSCI EAFE (International Developed)
5.0%–8.0%
17.0%
MSCI EAFE Small Cap (International Developed Small Cap)
5.5%–8.5%
19.7%
MSCI Europe
4.7%–7.9%
17.0%
MSCI Japan
5.0%–9.4%
21.0%
MSCI Emerging Markets
8.5%–13.4%
23.5%
Market Risk
Source: Balentine
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Disclosures The views expressed represent the opinion of Balentine. The views are subject to change and are not intended as a forecast or guarantee of future results. This material is for informational purposes only. It does not constitute investment advice and is not intended as an endorsement of any specific investment. Stated information is derived from proprietary and nonproprietary sources that have not been independently verified for accuracy or completeness. While Balentine believes the information to be accurate and reliable, we do not claim or have responsibility for its completeness, accuracy, or reliability. Statements of future expectations, estimates, projections, and other forward-looking statements are based on available information and Balentine’s view as of the time of these statements. Accordingly, such statements are inherently speculative as they are based on assumptions that may involve known and unknown risks and uncertainties. Actual results, performance or events may differ materially from those expressed or implied in such statements. Investing in equity securities involves risks, including the potential loss of principal. While equities may offer the potential for greater long-term growth than most debt securities, they generally have higher volatility. International investments may involve risk of capital loss from unfavorable fluctuation in currency values, from differences in generally accepted accounting principles, or from economic or political instability in other nations. Past performance is not indicative of future results. The Russell 1000® Index measures the performance of the large cap value segment of the U.S. equity universe. The Russell 1000® Growth Index measures the performance of the large cap value segment of the U.S. equity universe. It includes those Russell 1000 companies with higher price-to-book ratios and higher expected earnings growth rates. The Russell 1000® Value Index measures the performance of the large cap value segment of the U.S. equity universe. It includes those Russell 1000 companies with lower price-to-book ratios and lower expected growth values.
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Balentine LLC is an investment adviser registered with the U.S. Securities and Exchange Commission. Registration does not imply a certain level of skill or training. More information about Balentine’s investment advisory services can be found in its Form ADV Part 2, which is available upon request. Model results are hypothetical and do not reflect trading in actual accounts and are prepared with the benefit of hindsight. The model performance is a blend of the iShares Russell 1000 Growth ETF (IWF) and the iShares Russell 1000 Value ETF (IWD). The model performance is shown for informational purposes only and should not be interpreted as actual historical performance of ADVISER. Model results do not represent actual trading in client accounts, nor do they reflect client-specific activities, such as contributions, withdrawals, or restrictions. In addition, such results may not reflect the impact that material economic and market factors may have had if accounts had actual been managed by ADVISER during the entire period portrayed. The actual returns experienced by individual clients will differ due to many factors, including individual investments and fees, individual client restrictions, and the timing of investments and cash flows. Neither past actual nor hypothetical performance guarantees future results. No representation is being made that any model or model mix will achieve results similar to that shown and there is no assurance that a model that produces attractive hypothetical results on a historical basis will work effectively on a prospective basis. Client should not rely solely on this performance or any other performance illustrations when making investment decisions. Actual performance may differ from model results. The Simulated Tactical Portfolio is an illustrative portfolio that correctly shifted to the better performing asset class between Russell 1000 Growth and Value at the exact top and bottom of each cycle. This simulated portfolio is not designed to represent actual performance. The simulated performance is a blend of the Russell 1000 Growth Index and the Russell 1000 Value Index. The simulated performance is shown for informational purposes only and should not be interpreted as actual historical performance of ADVISER.
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