2021: Triumph of the Optimists PART II
I always write a longer piece at the start of a new year as a reflection on the year that has just passed. Last year I described this process as pulling out the nuggets from the last twelve months and weaving an interesting story.
We all love stories, after all.
I am just not sure that 2021 can stand alone as a story – it’s part of something greater. It is perhaps the second act to the drama that started at the beginning of 2020 when the world first got wind of this thing called COVID.
Two years later we still seem unsure of how to live with it. But that’s a thought for another day.
The story here began when the US stock market (defined by the S&P 500) fell 34% in 33 days. It did this in response to a virus that appeared to be shutting down the world and plummeting humanity into the depths of darkness.
Fortunately, as is always the case, we found a way out – vaccines (thanks to the smartest scientists on the planet being united in their goal for perhaps the first time in history) saved us medically and an extraordinary policy response saved us economically.
From the bottom of that crash to today, the market has returned 114%. The return in the calendar year 2020 was 18% and in 2021 it was 29%, including dividends. This time last year I wrote “stay optimistic – this next decade is going to be a wonderful time to be alive”. Whilst it’s still early days it’s certainly proved to be a wonderful time to be an investor!
I always reference the S&P 500 but it’s important to look to the world, because the S&P 500 only makes up a little more than half of the world equity market value. Once again in 2021 the S&P 500 was at the top of the leader board.
The chart below shows country returns.
Europe as a whole fared well with the two widely held European ETFs in client accounts returning over 20% (in USD).
The weak spots were a number of emerging markets and Asian countries.
The S&P 500 has been so dominant in its performance over the past 10 years that one can ask the question, why do we own anything else? It’s worth reminding ourselves why we stay diversified.
The primary reason is that diversification is the way in which we manifest humility – it’s our confession together that, although we have a very good idea what is going to happen in the long run, we can never know what’s going to happen next. NO ONE KNOWS. (The difference is that we admit it).
It goes a bit further than that though.
Equity diversification divides your assets among portfolios with different styles, different sectors and different countries. These portfolios have historically run on different cycles (growth v value, large cap v small cap, US v emerging). By owning a bit of it all we are able to reduce the shorter-term volatility of your overall portfolio whilst still earning the full return of all the components in the long run. What this means is that in any given moment we may suppress our return, because anything that suppresses volatility MUST also suppress return. This is not a flaw. It’s the fact that there is always something that is “under-performing” that tells you that you are indeed diversified.
To take it ever further, we know that the worst decision is to sell the portfolio components that are down to buy the ones that are up. Not only would that destroy our diversification but it would not be called investing at all, it would be called speculating or even worse, performance-chasing.
What I can say about emerging markets is that at some point, and I don’t know when, we will be very grateful to have exposure in our portfolio. During the “lost decade” of January 2000 to December 2009 the annualized return for the S&P 500 was -1%. Emerging markets on the other hand returned 9.8% per annum. Their day will come once again.
This time last year I discussed valuations as a possible headwind but I cautioned in using long term valuation metrics and making the conclusion that the US market is expensive. Whilst one wants to be very careful of using the words ‘this time it’s different’, I do think that we have to be open to the fact that this time it could be different.
This bull market in stocks has been driven by earnings growth. This is not like the dotcom bubble where eye-watering valuations were given to companies with no earnings. Earnings for the S&P 500 companies grew 65% in 2021. That’s the highest annual increase on record (the average earnings per share growth over the past 20 years is 6%). Because earnings growth outpaced price growth, the P/E ratio (a metric of valuation) fell from 30.7 at the end of 2020 to 23.6 at the end of 2021 (data from Charlie Bilello).
This is hugely important news.
Despite a stellar year for US stocks they actually got cheaper. It seems strange I know, but we don’t value stocks on their price, we value them in relation to their earnings. If earnings go up more than price they get cheaper. If price goes up more than earnings they get more expensive.
Last year I said I am not yet panicked by valuations. Given the fall this year my view now is that valuations are not much of an argument at all. As was the case last year, international and emerging markets look extremely good value when compared to the US market, supporting the reasoning for holding them in a diversified portfolio.
What did we learn?
As someone wiser than me once said, markets change constantly but good advice rarely changes. Good advice is not about what is working now, it’s about what has always worked.
The markets over the past two years have reinforced the lesson that neither the economy nor the market can be timed. While many advisers sell “selection and timing”, “tactical asset allocation”, “higher-risk adjust returns” or some form of miracle hedging, we calmy and simply state that mainstream equities are the most efficient and effortless (you as an investor are literally making money in your sleep) way to build and maintain a lifetime of wealth.
We understand both the power of compounding and the importance of never interrupting it unnecessarily.
We know that markets go down (we can’t know when) but they never stay down. We know that the only way to capture all the ups is to ride out all the downs.
We know that our lifetime success as an equity investor depends on our ability to continue to act on a plan. We know that failure comes from abandoning our plan and reacting to the market movements.
We know that there are always siren-songs out there, luring us onto the rocks, threatening to derail us. My job is to keep you steadfastly focused on what matters and what you can control.
Where do we go from here?
Last year I wrote:
When we emerge from this with herd immunity (either naturally or via the vaccine, hopefully the latter) and the economic and psychological impacts of the virus are behind us, to put it bluntly, humans are going to go wild. We are currently cooped up, saving money, being abstemious (as a whole, if not individually!). If history is a guide, we will enter a post-pandemic period where all the current trends are reversed. We will fill restaurants and bars again, we will travel again, concerts and sporting events will return.
I don’t make predictions but what seems most likely to me is that we see a continuation of the above. Omicron burns through and we start to see life actually return to normal in 2022.
Household net worth in the US is at an all-time high and the household debt service ratio is the lowest it has been since 1980. People have money and people have the desire to spend.
The crisis forced companies to be more efficient, to embrace technology and innovate. Earnings growth will continue to be driven by those forces and my guess is that equity values follow the same path, though perhaps not at the same rate of the last few years.
Ben Carlson once pointed out that you can win any argument in investing by changing your start date. Which is exactly what I am going to do here (everyone else does it, after all). If you look at returns of the US market since March 24th 2000, the day the dotcom bubble popped, you tell an interesting story. What has arisen since that date is two bear markets where stock prices were cut in half. Since that day the US market has returned 7.5% per annum, which is somewhat below the long-run average return of 10% or thereabouts. Nick Murray poses the question, could it be, that far from markets being “too high”, there are still just playing catch-up? An interesting question indeed.
With inflation hitting almost 7% in the US and interest rates remaining at all-time lows, it has never been more important to get your money out of a bank account and into the extraordinary wealth creating machine that is the global stock market.
Remember Peter Lynch’s famous words, “Far more money has been lost by people preparing for corrections, or trying to anticipate corrections, than has been lost in corrections themselves.”
Liberty Wealth update
Liberty Wealth is just over three years into this journey and we will soon hit the five year goals we set at the start (which I thought were ambitious). We have some exciting things on the horizon in 2022. Watch this space!
I thank every one of you, my amazing clients, who trust me with something as important as your financial life. It is and always has been a privilege to serve you. I am grateful every day that I get to do a job that I love, working with people that I love.
If you have friends or family that need help planning their future, please know that I am here to support them in the same way. And if you have comments, thoughts or suggestions on this newsletter or anything else that I do (or don’t do), send me an email or call me.
Best
Georgie
georgie@libertywealth.ky