THE LAST 12 MONTHS HAVE BEEN extraordinary and turbulent, witnessing the misery and dislocation wrought by the pandemic—but accompanied by the Dow Industrials, the S&P 500, and the Nasdaq soaring over 75% and more: Investors apparently became convinced that the outlook wasn’t as bleak as stock prices suggested last March. We said that a floor was being built under the economy and the markets, and that although headlines would emphasize the negative, the nation had been through upheaval before and would find its way out once again. We were correct. Now, what do we see ahead?
Strong Economic Signals
While economic data are always mixed, the emphasis is distinctly on positive momentum these days. Manufacturing in the U.S. reached a level this March not seen since 1983, consumer confidence is at a 12-month high, and unemployment is down to a pandemic low of 6%. Importantly, more and more Americans are getting vaccinated against COVID—74% of those over 65, while 38% of the adult population has gotten at least one dose.
At the same time, we believe that the Fed’s accommodative monetary policy will continue, as will fiscal stimulus out of Washington. Both should help drive faster real-GDP growth—to a level near 7% this year, up from our 4% forecast in January.
Four Pillars for Building Portfolios
In making asset-allocation decisions for our portfolios, we rely on four interrelated factors:
- Economics and the Macro Environment: As indicated above, we’re currently positive.
- Asset Valuations: We’re neutral, since no asset classes are cheap right now, though some are less pricey than others, and opportunities are available in select sectors and securities.
- Investor Sentiment and Market Trends: Even as we’re watchful for signs of “irrational exuberance,” we believe that sentiment today is generally supportive of risk assets.
- Risk: While we look at the usual benchmarks, like the standard deviation of returns, we’re mindful that to our clients, risk is better understood not as a number but as an outcome: the permanent loss of capital. Right now, we see the risk outlook for the market as manageable.
A year ago, we looked beyond the immediate crisis and invested with the expectation of improvement. Today, we see an environment favorable for risk assets, and so we’re maintaining an equity overweight.
Aren’t Stocks Expensive Now?
Some stock valuations are indeed rich—even in the 90+ percentiles. But profit margins are actually low, leaving many companies with room for big improvement. Further, with interest rates depressed in bonds and cash, while those asset classes remain critical assets for most private investors, the near-term prospects of stocks are, we think, more favorable.
And importantly, while 2020’s banner stock returns were largely concentrated in a few tech-related stocks—Facebook, Apple, Netflix, Microsoft, Amazon, and Google (Alphabet)—this year winners so far are from a much broader group of sectors, a development we’ve been waiting for. The tech stocks are great companies (and we still want to own them, albeit in lesser amounts), but they’re too expensive to be overemphasized investments. This brings us to two key rotations we’re seeing in the stock market, at least for the near term.
Shift Toward Value and Small-Cap
For one, after years of dominating stock returns, Growth stocks have lost some of their luster as investor attention appears to turn to Value, led by financial companies and economic cyclicals. With this in mind, we’ve moved our portfolios closer to style-neutral by taking some profits in Growth stocks and using the funds to increase our weighting in Value.
The other market shift has been the outperformance of small-cap stocks. So for the first time in 10 years, we’ve tilted our portfolios toward smaller companies. Small-cap has led because it’s heavier in cyclical companies and health care, lighter in tech (11% of one major small-cap index vs. 30% for large-cap), and more domestically oriented than large-cap stocks in a year we expect U.S. growth to lead the world.
We’re watching these apparent rotations carefully; neither is definite or necessarily long-lasting
Stay with High-Quality Bonds
Meanwhile, many clients are understandably concerned about the effects of a recovering economy on interest rates, even as rates remain very low. Low rates poised to rise are a bad combination for bonds, which had modestly negative returns last quarter and may repeat their performance this quarter. Many bond investors looking for income and more security have been tempted to venture outside short- and intermediate-maturity Treasuries and other high-quality bonds to longer-dated or lower-rated securities.
As we see it, now is not the time to be taking maturity or quality risks with bonds. For most investors, bonds are the ballast of their portfolios. Precisely because the environment for bonds right now is not favorable, taking extra bond risk is the wrong strategy. Our portfolios remain anchored in moderate maturities (less sensitive to price declines than long bonds when interest rates rise) and high quality.
Strategies as Tax Season Peaks
The IRS has given taxpayers an extra month to file. For us and for you, that means thinking about tax loss-harvesting to offset gains in your taxable accounts, when harvesting makes tax and economic sense. Beyond loss-harvesting, we remain vigilant year-round about tax efficiency in taxable portfolios, which puts more money in our clients’ pockets. And in all our allocation changes, we want to avoid very short-term moves in favor of those with at least 12-18-month time frames: a strategy good for taxes as well.
Our New Emerging Partnership
As you probably know, we expect to combine with M&T Bank/Wilmington Trust at the start of the fourth quarter of this year. We couldn’t be happier about joining forces with another leader in the banking industry that shares our client focus, our culture of community involvement, and our commitment to offering a rich slate of financial services. We look forward to continuing our relationships with our clients and providing them with even more resources in the future.
As always, we value your confidence and welcome the opportunity to help you with your financial issues.