A Year to Remember and Forget
2020 IN REVIEW
2020 was an absolutely breathtaking year in more ways than one. Financial markets certainly exhaled a long sigh of relief following what was the fastest bear market in history (just 20 days) followed immediately by the fastest recovery ever (in 126 days). The global equity market ended the year up +15.15% (as measured by the ACWI).
While that may not seem remarkable by itself, that was after clawing back a -34% drawdown from Q1 for an aggregate rally of +50%! And of course, we can’t ignore the near parabolic moves we saw in some tech stocks and cryptocurrencies. Suffice to say we don’t see those kinds of moves very often.
Figure1: Global Equity Market
In last January’s letter, I wrote markets had “come full circle in course of a decade,” from the gloomy financial crisis depths of 2009 to the euphoric all-time-highs of 2019. At BCM we grew increasingly cautious and I wrote “we expect our next move to be a reduction of risk exposure and are postured to do so when economic and market conditions warrant.”
I had no idea of how soon or how quickly we would subsequently need to act.
Fortunately, being prepared for de-risking helped us avoid the worst of the March drawdown. However, we also did not re-risk fast enough to fully participate in the surge that followed. That reflects the difficulty of accurately and precisely timing market turning points (very hard and utterly impossible to do consistently).
In terms of value-seeking, we also had winning and losing calls, as usual. Our biggest loser was our long call on the Pakistani stock market which got destroyed during the Q1 sell-off and was down -43.38% into April. It did have a spectacular +53.81% rally off the bottom but PAK still ended the year down -5.45%.
On the other hand, our long call on emerging market equities worked favorably, with EEM gaining +17.47% for the year and outpacing ACWI. Our long position in silver was also an outperformer with SLV gaining +47.57%. And the biggest winner was our long call on the VIX (via VXX), which spiked +500% from peak to trough in Q1 and ended the year up +351.79%
Figure 2: Long Calls 2020
MACRO VALUE IS NOW “TACTICAL VALUE”
Before we pivot to the year ahead, an update about the Macro Value strategy (MV). The strategy has been renamed to “Tactical Value” (TV). The core principles of the strategy still remain, a market-level approach with an emphasis on value. But the change reflects the culmination of an issue I have been writing about for over two years.
With the decade-long rally in risk assets ongoing it’s become increasingly difficult to find the “unreasonably undervalued” market opportunities MV seeks. For the strategy, it created the rising risk of being underinvested (due to lack of compelling value opportunities) in a widely risk-on environment where valuations didn’t seem to matter.
I began addressing the issue in 2019 by incorporating a “target risk allocation” (or TRA) framework into the strategy, adopted from our aptly named “Tactical Allocation” strategy. I elaborated on the adjustments last year.
In summary, the TRA helps the portfolio stay within maximum and minimum levels of risk exposure regardless of valuation -- like guard rails designed to help prevent the strategy from going too much over or underweight during certain economic and market conditions.
After the TRA is set, the strategy still looks to fill the allocation with undervalued market opportunities first. However, if there is a dearth of value in a risk-on environment, then we fill the TRA gap with broad global equity market exposure via the ACWI.
The rationale is in a risk on-environment, broad equity market exposure is the next best thing absent other compelling, value opportunities. The reverse is true in a risk-off environment, we reduce risk exposure by trimming allocations in ACWI and value positions as appropriate.
2020 showed just how important the TRA adjustments were as global markets made extreme swings both ways with little to no regard for valuations. As a result, the TRA decisions had a significantly larger impact on the strategy's results than the value positions did.
That won't always be the case, but the point is TRA will likely continue to have an impact on results moving forward and is not going away. Hence, the name-change to Tactical Value.
We entered 2020 with a neutral position on risk exposure. While 100% risk allocation (or even more with leverage) would have been most lucrative, the opposite extreme seemed more prevalent among investors. In other words, many investors sat in cash and watched from the sidelines (in horror and disbelief) as equity markets made one record high after another.
We avoided both extremes by shifting from underweight to neutral weight after the sell-off in Q1 2020. Although we recognized conditions were far from being “all-clear,” we also understood markets could rise on marginal economic improvements (where conditions look relatively better or worse, instead of absolutely good or bad). Looking back at leading indicators, that much happened.
Figure3: OECD Composite Leading Indicators
Looking ahead, we are once again beginning the year with neutral risk exposure and cautious optimism. Optimistic because at this point it appears a number of uncertainties that haunted investors are being laid to rest. By year-end 2020, COVID vaccines were being administered, a second wave of stimulus was rolling out, and the contentious POTUS election was coming to an end. Barring any new shocks and all else equal that sets a favorable backdrop for global risk assets.
But we are still cautious because there are a couple of lingering skeletons in the closet that have kept us from going overweight risk exposure. First, the marginal economic improvements we saw in 2020 have moderated. Just as relatively better data was enough to propel markets upwards, relatively worse data ahead could be enough for markets to take a dive. That turn could be especially acute because equity markets have already priced in positive expectations and are bouncing around all-time highs.
Figure 4: The Conference Board Leading Economic Indicators
Those all-time highs bring us to the second issue, valuation (particularly germane to Tactical Value). While investors can always find new measures to justify current prices, global equity markets look high based on historically reliable valuation measures. See below that market cap to GDP and the CAPE ratio reached their highest and second-highest levels ever, respectively.
Figure 5: Market Cap to GDP
Figure 6: Shiller CAPE Ratio
To be fair, I wrote in Q3 equity prices may be less extreme than they appear on the surface due to abnormally low interest rates. That’s still true and argues that just because prices are high doesn’t mean they won’t go even higher. At the same time, saying an overvalued asset can become even more overvalued is a poor argument for increasing exposure. Our neutral risk positioning reflects our respect for both sides of the argument.
Market valuations remain elevated across asset classes and at best we see pockets of relative value. Here are a few pockets we’re rummaging in.
Black Gold and Company
In April of 2020 I pointed out “black gold” or crude oil was one of the few compelling values in view. In hindsight, crude was a perfect example of the “unreasonably undervalued opportunities” we search for as WTI crude prices went negative for the first time in history (based on futures) – something I wrote was “utter nonsense.” I expected a reasonable fair value for WTI to be $40 to $50 per barrel based on global average breakeven levels and crude ended the year at over $48.
Figure 7: WTI Crude Oil Prices
At this point crude no longer looks like the unreasonable value it did. However, in relative terms, it also does not look as overpriced as other choices (e.g. stocks and bonds). There’s also the non-negligible possibility that oil prices could overshoot to the upside just as they overshot to the downside. Don’t forget only a few years ago many believed oil prices would not fall below $100 per barrel again. It’s possible we could revisit those levels if the current expansion gains momentum.
Closely related to crude, and another way to play oil, are energy sector stocks. The US energy sector trailed the broader equity market last year by a wide margin. Energy stocks, as measured by XLE, ended 2020 down -32.10% (versus +17.24% for the S&P 500).
Figure 8: Energy vs Broad Markets
The underperformance is understandable given the chaos in the crude market. And while there are still skeletons lurking in the energy closet (weak fundamentals, financial health, challenging secular outlook, etc.), the sector is also priced at a significant discount to the S&P 500. Not only that but energy is also the least expensive US equity sector by a meaningful margin.
Figure 9: US Equity Valuations
In addition to potential further upside in oil prices and attractive valuation, energy has one more positive thing going for it – an apparent rotation into value.
Resurrection of Value
It’s well known that value stocks have lagged growth stocks (like FANGMAT and company) for years. And as of 2020, the outperformance of growth versus value reached an all-time high, even more pronounced than during the dot-com boom. As a result, many investors left value stocks and value investing for dead.
Figure 10: Growth vs Value
In November, I noted value stocks could be on the cusp of a turnaround should investors rotate out of growth and into value. My timing appears lucky as value stocks actually began outpacing growth that very month and into the end of the year.
Figure 11: R1000 Value vs R1000 Growth
Luck aside, there are rational reasons why value stocks may come back to life. Despite a long period of underperformance, value stocks have an even longer history of statistically-significant return premium over growth stocks of around 300 basis points – known as the “value premium” (h/t Fama and French).
However, while significant, that premium was only observed about 60% of the time. That means periods of growth outperforming value should happen quite often (about 40% of the time) and not be a surprise.
Figure 12: Value Premium
In addition, value stocks have actually performed in line with their historical norms. As of 2019, the 10-year annualized return on US value stocks was 12.9% versus a long-term annualized return of 12.7%. On the other hand, growth stocks returned 16.3% versus a long-term return of 9.7%. In other words, value stocks behaved as expected over the past decade and the performance of growth stocks has been the real abnormality.
Figure 13: Abnormal Returns
The point is it is unlikely that value stocks are “dead for good" and more likely they are waiting for a catalyst to resurrect. As for what that might be, other than simple mean reversion, the pandemic recovery could be such a catalyst.
To understand why; consider how investors crowded into a small number of big tech bellwethers during the pandemic. That happened, in part, because investors expected those few companies would be the best positioned to grow in the face of lockdowns and economic weakness. In other words, investors crowded into growth stocks as the outlook for economic growth became scarce.
It stands to reason then that as the global economy continues to reopen and expand post-COVID, even marginally (which is our base case expectation), market strength should broaden. In other words, investors should rotate out of a narrow range of growth stocks into a wider range of more cyclical stocks that will benefit from increased economic growth. That includes value stocks in general, the energy sector in particular, and a wider range of material and commodity-related markets (which I will write about in a future note).
THE BOTTOM LINE
We are heading into 2021 with similar cautious optimism and risk positioning as last year, but for different reasons. While markets seemed care-free and exuberant at year-end 2019, there was more anxiety at year-end 2020, and for good reason given all that happened during the year. I think that reflects a healthy dose of skepticism that markets need to function correctly.
Pairing that with our base case expectation of continued marginal global growth coming out of pandemic mode and we see near-term support for risk assets. Of course, with prices and valuations near all-time highs across asset classes that dose of skepticism is especially important. To that end, we refrain from going overweight risk exposure at present. From a valuation perspective, a couple of areas we favor include the US energy sector stocks and more broadly value stocks in general.
2020 was a tumultuous year that many would like to forget but will instead likely remember as the year that changed everything -- from how people behave to how business is done. It’s certainly changed things at BCM, from almost a year of working-from-home to adjustments to Macro (now Tactical) Value.
Despite all the changes, some things remain the same. At BCM we continue to stay vigilant and grateful for the many clients who entrust us with their financial futures. Thank you for your confidence and support, we appreciate you and look forward to seeing you in the brighter days ahead.
Victor K. Lai, CFA