Quarterly Letter

January 2021 – Quarterly Letter

By January 25, 2021 No Comments

January 25th, 2021

2020 is in the rearview mirror. Most years, turning a page on a calendar is mere symbolism. This year, the changing of the calendar coincides with titanic shifts in the management of the economy and the federal government.

The market is looking past the COVID related earnings slowdown as investors are increasingly encouraged that vaccines will mitigate the transmission of the virus. After enduring the last 11 months of lockdowns and social distancing, I am beginning to understand why the Roaring Twenties immediately followed the 1918 flu epidemic.

The U.S. economy is operating at about 90% strength. The question is not if the pandemic will end, but when. Despite the initial pace of vaccinations as production ramps up and more vaccines are approved, the percentage of the population that possesses immunity will skyrocket.

One result of social distancing is that the household savings rate has exploded. The household financial obligations ratio, a measure of debt service obligations, is as healthy as it has ever been. Strong housing prices and stock market returns means that U.S. household net worth is greater than at any other time in history.

There is plenty of cash available for consumers to spend once we get the green light.  We can anticipate that a wave of pent-up demand will flood the economy. Eventually, this should trigger inflation and higher interest rates, but with the current high level of unemployment it will take some time before wages move higher. The Federal Reserve seems inclined to wait at least until 2023 to raise interest rates.

Recovery from the pandemic will be a huge boon to travel companies, airlines, restaurants, and hotels as people return to activities away from home. Industries that benefit from a general economic recovery like apparel, consumer finance and transportation also seem primed to outperform. 2021 seems to favor the industries that suffered the most from the lockdown.

The most economically sensitive industries comprise the value segment of the market. After ten years of underperformance, value, small and international stocks are currently leading the market. The rotation from growth industries towards value began in the fall following positive vaccine trial results from Pfizer and Moderna. We continue to maintain a substantial allocation to industries that will most benefit from the re-opening.

We will not completely go back to the way we were. The pandemic accelerated some permanent structural changes. It is possible that we will never spend as much time in the office again. Employees and managers have learned that working remotely is quite feasible with the tools that are available to us today. The LTE network can support zoom meetings from pretty much anywhere. The rollout of the 5G network will increase the availability of wireless high-speed internet. As people become increasingly familiar with the tools to effectively work remotely it should continue to gain acceptance.

We own several companies that build the telecommunications infrastructure. Nvidia is the leading supplier of computer chips that facilitate the 5G network. Cable companies are losing television subscribers, but they are adding internet subscribers. Comcast and Charter earn more revenue from an internet subscription than a television subscription. Apple supplies the devices, and T-Mobile provides mobile network access.

Think about how much you spent over the past year. Now think about how much of that spending was in the form of cash. Society is shifting away from cash and towards online payment systems. Services like Venmo, PayPal and Square are facilitating cash payments between small business and individuals. The theme of a cashless economy is well reflected in our portfolio with holdings like Visa, Mastercard and PayPal. This transition will continue over several years and is global in nature. The companies that build and control the payment networks have a near-monopoly which allows them to generate an extremely high profit margin.

Our 2020 stock portfolio return of 22% exceeded expectations. The S&P 500 gained about 17%. It is currently at 3,850. Strong earnings growth in 2021 and 2022 should allow the S&P to increase to as much as 4,400 by the end of this year. That implies a 2021 gain of about 14% before dividends, which would exceed our long-term equity return projections.

The consensus forecast is for about 6% GDP growth in 2021. Earnings will grow faster than the overall economy. Expectations are that earnings for the S&P 500 will grow 17% next year. If the Federal Reserve retains control and keeps interest rates low, the price-to-earnings ratio for stocks should stay relatively constant. Economic fundamentals support a relatively optimistic outlook for the stock market.  The market does better than average when the economy is growing, and earnings are increasing.

The change in political control will have a modest impact on the economy, but not as much as most people think. The market can do well under both Republican and Democratic administrations. Over the last four years, fiscal policy was accommodative. Taxes were cut and spending increased. Both Republicans and Democrats agreed on the need to support the economy through the pandemic. The tax cuts also acted as economic stimulus. This stimulus was offset by higher taxes on trade.

Now that Democrats control both the legislative and executive branch of government, I suspect that Republicans will be less supportive of fiscal stimulus. The Democrats will not cut taxes, but they will not make much progress towards increasing taxes given the evenly divided Senate. We might see some reduction of the tariffs on Chinese trade, but not an elimination. Spending will probably come down eventually, as the Republicans revert to their traditional opposition to government spending. The need to support the economy through the pandemic will most likely push any spending cuts out to 2022 at the earliest.

It has been a tough year and an especially tough winter. Vaccine distribution got off to a slower start than anticipated, but distribution is accelerating. It took twenty-three days to administer the first five million doses. Today, we are distributing about 5 million doses every four days. This rate should continue to increase.

If all goes well according to Dr. Fauci, we hope to return to some normalcy by the fall. As we become increasingly confident that the worst is behind us, the market should rally. It would be much more surprising to see a falling market versus one that exceeds our expectations to the upside.

Eric Barden, CFA